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Full text of "Cases in controllership"

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UNIVERSITY 
OF FLORIDA 
LIBRARIES 




Digitized by the Internet Arcliive 
in 2013 



http://archive.org/details/casesincontrolleOOhass 



Cases In 
COXTROLLERSHIP 



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CASES IN 
CONTROLLERSHIP 



Russell H. Hassler 

Professor of Accounting and Associate Dean 

Graduate School of Business Administration 

Harvard University 



an< 



Neil E. Harlan 

Assistant Professor of Business Administration 

Graduate School of Business Administration 

Harvard University 



PRENTICE-HALL, INC. 

Englewood Cliffs. N. J. 
1958 



© 1958 BY 
PRENTICE-HALL, INC. 

Englewood Cliffs, N. J. 

all rights reserved. no part of this book 
may be reproduced in any form, by 
mimeograph or any other means, with- 
out permission in writing from the 
publishers. 

Library of Congress 
Catalog Card No.: 58-12015 



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/./ 


n\A 



PRINTED IN THE UNITED STATES OF AMERICA 

11868 



Preface 



The purpose of this book is to provide a collection of case 
materials that will be useful as a basis for study of that area of busi- 
ness management generally known as controller ship. The book is not 
intended to provide technical training in accounting; in fact, it 
assumes a knowledge of the fundamentals of accounting. The mate- 
rials included in the book are designed to provide the student a 
means of gaining an understanding of an important dimension of the 
controller function which is frequently overlooked in accounting 
curricula— the relationship of the work of the controller or financial 
officer to the operating functions of the business organization. The 
book also places heavy emphasis on the analytical aspects of the 
controller function. The aim is to develop skills of analysis and 
practice of judgment through a series of experiences with actual 
business situations. 

All of the cases in this book were developed for use in courses at 
the Harvard Business School, and are copyrighted by the President 
and Fellows of Harvard College. 

A number of people have been instrumental in bringing this book 
into being. Many of the cases were prepared by William Rotch, 
William Jerome HI, John Hamilton, and Richard Kislik, as staff 
members of the Harvard Business School. Professors Edmund P. 
Learned and Robert N. Anthony have also contributed to the case 
materials. Miss Jane Clark and Miss Justine McCarthy have borne 
the brunt of the secretarial work. To all of these, and to the com- 
panies who made it possible for the cases to be collected in the first 
place, we are particularly indebted. We of course owe much to the 
influence, through their counsel and advice, of many colleagues 
and associates; their contributions, although not so direct and ap- 
parent, are nonetheless real. 

R.H.H. 
N.E.H. 



List of Cases 



SECTION ONE 

The Nature of the Controller Function 

1. HUTTER COMPANY: Organization for Management Control 8 

2. ARGOSY CHEMICAL CO.: Placing the Budget Function in 

the Organization 29 

3. THE BEARDSLEY CHEMICAL COMPANY: Decentralization 

of Accounts Receivable 31 

4. STRATFORD FOODS, INCORPORATED (I): Organization 

of the Accounting Function 36 

5. BEECROFT MANUFACTURING COMPANY: The 
Formulation of Accounting Statements and Their Use by 

Senior Executives 46 

SECTION TWO 

Internal Control and Internal Audit 

6. OATSY-TOASTY COMPANY: Problem of Internal Control 54 

7. HARTSHORN FURNITURE COMPANY: Problem of Internal 
Control 64 

8. HILLYARD IRON WORKS, INCORPORATED: Raw 

Material Control 65 

9. DRAYER-HANSON, INCORPORATED: Work in Process 
Inventory Control in the Matter of Drayer-Hanson, Incorporated 71 

10. ALGONQUIN RUBBER COMPANY: Control of Repair and 
Capital Costs 81 

11. STRATFORD FOODS, INCORPORATED (II): Establishing 

a Program of Internal Audit 100 

12. RICHLAND CORPORATION: Follow-up of an Internal Audit 105 



viii LIST OF CASES 

13. NORTHERN ALLIANCE COMPANY: Internal Audit Report 128 

14. THE DOLPHIN MANUFACTURING COMPANY: The 
Internal Audit Follow-up 137 

15. THE WESTCO OIL COMPANY: Functional Internal Auditing 
Activities 149 

SECTION THREE 

Accounting Policy 

16. CONSOLIDATED LEATHER COMPANY: Selection of 
Method of Inventory Valuation (LIFO) 158 

17. BALFORD AUTOMOTIVE PARTS, INCORPORATED: 
Procedures for the Control of Fixed Asset Additions 175 

18. TERRINI CONSTRUCTION COMPANY: Purposes of 
Depreciation 183 

19. SHIPSTEAD ELECTRONICS CORPORATION: Depreciation 

of Fixed Assets 188 

20. BIGHORN DRILLING COMPANY: Depreciation Policy 193 

21. THE REECE CORPORATION: The Impact of Inflation on 
Corporate Reporting 210 

22. THE PAN AMERICAN CORPORATION: Intangible Assets 214 

SECTION FOUR 

The Role of Financial Analysis in the 
Management Process 

23. STAR SLIPPER COMPANY: Problem of Product Mix 219 

24. BOWL- A- WAY: Appraising Capital Expenditure Projects 226 

25. CONTINENTAL OIL COMPANY: Appraisal of Capital 
Investments 231 

26. VELOX OIL COMPANY: Capital Investments 251 

27. BLACKSTONE MINING COMPANY: A Problem in Business 
Investment 262 

28. ACADIA AUTO ACCESSORIES, INCORPORATED: Self- 
Insurance on Workmen's Compensation 266 

29. THE NEW ENGLAND BAKING COMPANY: Review of 
Insurance Carrier 279 

30. GLOBAL CHEMICAL COMPANY: Control of Research 
Expenditures 292 



LIST Of CASES ix 

31. THE SOUTH AMERICAN COFFEE COMPANY: Data for 
Management Use 302 

32. ALBERTSON STEEL COMPANY: Cash Procedure and 
Control 307 

33. THE WRIGHT KNIGHT COMPANY: Measures of 
Performance 321 

34. HYDROCARBON PRODUCTS COMPANY, INC.: Transfer 
Pricing 323 

35. BIRCH PAPER COMPANY: Administering Transfer Price 
Policy 334 

36. LONG MANUFACTURING COMPANY: Allocation of Assets 

to Decentralized Divisions 337 

37. BORAH PETROLEUM COMPANY: Analyzing and Reporting 
Operating Results 340 

38. CLARK CHEMICAL COMPANY: A Question of Jurisdiction 349 



Cases in 
CONTROLLERSHIP 



Introduction 



This book is a collection of cases dealing with the task of providing 
information for business management. More specifically, it is concerned 
with the collection, analysis, interpretation, and presentation of infor- 
mation—usually figure data— which are important bases for management's 
decision-making and follow-up activities. 

The Controller Function 

The collection, analysis, interpretation, and presentation of manage- 
ment information are generally grouped under the term controller 
function. The controller, or his equivalent, typically reports directly to 
the president or through an intermediate level such as the vice-president 
of finance. In some instances a portion of the controller function may even 
be performed by another department of the business organization, for 
example, an "economic analysis" department, or a department for 
"coordination and planning." We should emphasize that the term 
"controller function" as used here, does not mean merely the job of re- 
cording accounting data. It embraces the broader function which, in addi- 
tion to accounting activities, also provides, through its analytical and 
interpretive skills, accounting and statistical information tailored to spe- 
cific needs of management. 

Development of the Controller Function 

The growth of the controller function from the job of keeping the 
accounts of an enterprise into the broader role which it now plays in 
business management has been, for the most part, a development of the 
twentieth century. And it has been only since the early 1930's that the 
function has reached anything like a professional status. The broadening 
scope of the controller's role beyond that of custodian of records was 
emphasized by the formation, in 1931, of the Controllers Institute of 
America. The purposes set forth by the Institute attest to the recognition 



2 INTRODUCTION 

of this broader responsibility of the controller. These were: 

1. To develop a progressive concept of controllership, adequate to 
meet the requirements of modern business; 

2. To educate business management and the public in the understand- 
ing of this concept; 

3. To assist controllers to give full expression to this concept in their 
own organizations; 

4. To provide controllers with a medium through which they may 
receive and exchange ideas in the field of business management; 

5. To constitute an articulate body of management opinion on matters 
within the scope of the controller's responsibility; 

6. And, by doing these things, to contribute toward soundness in 
business, in education, in government, and in the national 
economy. 

The Institute also compiled the following list of duties of the controller, 
which provides an indication of that organization's view of the functions 
of its members. 

1. The installation and supervision of all accounting records of the 
corporation. 

2. The preparation and interpretation of the financial statements and 
reports of the corporation. 

3. The continuous audit of all accounts and records of the corporation 
wherever located. 

4. The compilation of production costs. 

5. The compilation of costs of distribution. 

6. The taking and costing of all physical inventories. 

7. The preparation and filing of tax returns and the supervision of all 
matters relating to taxes. 

8. The preparation and interpretation of all statistical records and 
reports of the corporation. 

9. The preparation, as budget director, in conjunction with other 
officers and department heads, of an annual budget covering all 
activities of the corporation, for submission to. the Board of 
Directors prior to the beginning of the fiscal year. The authority 
of the controller, with respect to the veto of commitments or 
expenditures not authorized by the budget, shall, from time to 
time, be fixed by the Board of Directors. 

10. The ascertainment currently that the properties of the corporation 
are properly and adequately insured. 

11. The initiation, preparation, and issuance of standard practices 
relating to all accounting matters and procedures and the co- 



INTRODUCTION 3 

ordination of systems throughout the corporation, including 
clerical and ofRce methods, records, reports, and procedures. 

12. The maintenance of adequate records of authorized appropriations 
and the determination that all sums expended pursuant thereto 
are properly accounted for. 

13. The ascertainment currently that financial transactions covered by 
minutes of the Board of Directors and/or the Executive Committee 
are properly executed and recorded. 

14. The maintenance of adequate records of all contracts and leases. 

15. The approval for payment (and/or countersigning) of all checks, 
promissory notes, and other negotiable instruments of the corpo- 
ration which have been authorized by the by-laws of the corpo- 
ration or from time to time designated by the Board of Directors. 

16. The examination of all warrants for the withdrawal of securities 
from the vaults of the corporation and the determination that such 
withdrawals are made in conformity with the by-laws and/or 
regulations established from time to time by the Board of Directors. 

17. The preparation or approval of the regulations or standard 
practices required to assure compliance with orders or regulations 
issued by duly constituted governmental agencies. 

Clearly, the controller, if he was to serve the broader purposes en- 
visioned by this new segment of a professional management, had to 
expand the scope of his activities to include far more than the con- 
ventional accounting operations of the past. 

However, if the controller function was enormously expanded from 
the beginning of the 1930's through World War II, its growth since 
World War II, and especially during the period from 1950, has been even 
greater. The new attention given to the area of capital budgeting during 
recent years is an outstanding example. The wider recognition of the 
present worth of future flows of money has just begun to work its way 
from the financial world into the bailiwick of the industrial controller. 
The concept of return on investment as a measure of performance in 
decentralized divisional operations was until fairly recently new to all 
but a few business organizations. The number of companies which make 
extensive use of economic and statistical analyses as an aid in the decision- 
making process is still not impressive; and operations research depart- 
ments have only begun to concern themselves with the process of business 
management. Their mathematical tools will undoubtedly, in due time, 
be brought to bear on the problems of business analysis. AnaMical 
processes which in the past have been well beyond the reach of the 



4 INTRODUCTION 

controller function are daily being made feasible by high-speed com- 
puters. 

The extension of the controller function has created new problems for 
the student who would prepare himself to take part in this important 
phase of business management. It is no longer sufficient that he attain a 
reasonable mastery in the field of accounting; for he may, when he moves 
onto the management scene, find himself responsible for a variety of 
economic, statistical, and mathematical analyses— all in addition to the 
more or less central function of processing accounting information. And 
if these analytical processes are to provide useful information for 
operating management, the controller must be able to communicate the 
results effectively. Consequently, he must have sufficient knowledge of 
the production, marketing, and financial functions to permit him to work 
intelligently with individuals directly concerned with these areas. He 
must also have an understanding of the more general management 
functions of organization and planning. The formal training offered the 
student interested in preparing for this area should be adapted to 
this basic change in the nature of the controller function. 

Scope of This Book 

In this book, we are not talking about what controllers do. This is not a 
manual on how to be a controller. The list of cases is not all-inclusive; it 
does not "blueprint" the controller's job. It is, instead, a collection of 
materials designed to show what the controller function, in its broadest 
management sense, is. The authors have not included problems which 
deal specifically with accounting technique, systems design and instal- 
lation, selection of accounting equipment and personnel, etc. This is not 
to minimize in any sense the importance of these areas, however. A 
number of excellent books which deal effectively with this type of 
training are already available, and it is not our intention to duplicate, or 
add to, these materials. 

It is, of course, inevitable, in discussing a range of issues which the 
controller may face in his role as adviser to management, that some of 
the actual problems involved in operating a controller organization will 
be raised. The main thrust of the book is, nevertheless, to the more 
inclusive nature of the controller function as an integral part of manage- 
ment. It includes, therefore, cases selected and developed from situations 
typical of the wide range of problems with which the controller is 
concerned— cases which offer a number of opportunities, in a "real 
world" business context, for the development of the analytical skills 
which provide one of the qualifications most essential to an effective 
role for the controller in business management. 



INTRODUCTION 5 

It has almost become trite to say that the controller's job is to render 
a service to management. One would probably find it difficult to point to 
a controller anywhere who would not support this view. Yet we continue 
to hear stories of sharp conflict between operating departments and the 
controller's office. Mr. Botts of the Earthworm Tractor Company is not 
alone in his contempt for that "damned penny-pinching controller." 

Perhaps a part of this conflict comes from a lack of agreement on what 
constitutes "service to management." Too often, the controller's office 
creates the impression that by "service" it means telling operating depart- 
ments how to run their jobs. The authors believe, however, that by far the 
most common reason for conflict between the controller and the operating 
departments is not disagreement over jurisdiction, but simply poor 
communication. Frequently in reporting operating results— the production 
of goods and services— and measuring them against the amount of 
materials and effort expended, the controller is the bearer of bad news. 
Although his attitude may be one of strictest objectivity and his work 
a model of technical application, he may, and too frequently does, 
incur the wrath of the supervisor whose substandard performance is 
being reported. Clearly, technical competence and objectivity are not 
enough. The controller needs, in addition, an understanding and a 
special outlook. He must have a respect for the desires and motivations of 
the individuals who have created the results which he must reduce to 
figures and report to management. To perform this unhappy duty, and 
still preserve the effective working relationship which must exist between 
the controller and the management he is to serve, provides perhaps the 
ultimate test of the controller's skill. Unless he can fulfill this requirement 
effectively, his chances of success as a part of total management— the 
management team— are materially reduced. 

Some Comments on the Use of Cases 

This book contains no textual materials, and in that respect differs 
markedly from the great majority of "text books" in the field of accounting 
and control. Since the book may represent the student's first experience 
in dealing primarily with case materials, it is perhaps necessary to point 
out two important differences which may exist between a "case method" 
approach and the more widely used "text" approach in studying the 
general field of accounting. 

In the "text" approach, the usual procedure is to introduce the student 
to a particular technique or tool and then illustrate, through problem 
materials, how the technique or tool is applied. In this book the focus is 
almost exclusively upon management problems, leaving to the student the 
burden of providing, either from prior training or from supplementar)' 



6 INTRODUCTION 

reading and study, the mechanical or analytical tool needed. This shift 
of focus may seem burdensome at first, but as the student progresses 
it should become natural to him. Needless to say, in the business world 
management problems do not present themselves together with a package 
of instructions as to how they should be solved. 

The second distinction between the materials in this book and those of 
a majority of the textbooks with which most of the students using the 
book will be accustomed is that there is no one "correct" solution to a 
case. The instructor has, or should have, no answer to hand the student 
at the end of the class hour. If he has, it should not automatically be 
regarded as the only correct answer. The instructor's role will be to 
require the student to test his own reasoning and defend his position, 
through class discussion, against the questioning and examination of class 
members, who may have used different approaches, and of the instructor 
whose interest will be primarily in seeing that the student's decisions 
reflect breadth of view as well as depth of analysis. The student must be 
able to see the problem as his problem, his decision— not one which he is 
solving for someone else. That is simply to say that the closer the student 
can come to seeing management problems through management's eyes, 
the more nearly he is approaching the time when he can perform a part 
of the controller function himself. 

The materials included in this casebook provide numerous oppor- 
tunities for the student to apply and develop his technical training in a 
total, living, administrative structure and climate, of which he is a vital 
part and where the relationship between the controller and operating 
management— not in some vague general sense, but in specific concrete 
situations— is always a concern. It is hoped that the repeated experience 
of attacking the controller's problems in their natural context will 
encourage and aid the student in turning a technical competence into an 
effective management skill. 



section ONE. 



The Nature 
of the Controller Function 



This section deals with the problem of relating the control function 
organizationally and administratively to the broad area of business 
management. The case materials focus on the question of how the 
controller function may best be fitted into the organizational structure to 
facilitate the use of accounting and statistical data in the management of 
a company's operations. Some of the difficulties in fixing duties and 
responsibilities for the performance of this function are examined. The 
job description, the title, and the organization may vary from one case to 
another, but the central issue in all the cases is the function of providing 
and interpreting quantitative information for management's use. Major 
attention is directed to the important and ever present problem of 
establishing an effective working relationship between the controller 
and the various other members of the management team. 

1. Hutter Company 

2. Argosy Chemical Co. 

3. The Beardsley Chemical Company 

4. Stratford Foods, Incorporated (I) 

5. Beecroft Manufacturing Company 



case 



HUTTER COMPANY 

Organization for Management Control 

This case raises the question of how to organize the controller 
function to facilitate control by top management in an atmosphere 
where the avowed intention of the management is to encourage 
decentralized management action. Also involved in this case is the 
problem of adapting the controller function to fundamental changes 
in the nature of a company's operation— in this instance from a 
< reasonably non-competitive war-defense-type effort to the highly 

competitive conditions of a postwar civilian market. 

Background 

The Hutter Company was founded during World War I by a 
small group of men primarily interested in automobile stunt racing. 
They organized the company to make fabricated parts for military 
aircraft engines. When the war ended, the company had two small 
plants, no peacetime products, an organization young both in age 
and in the maturity of its experience, and few financial resources. 
The readjustment period that followed the war was therefore diffi- 
cult. According to Mr. Daniel Hall, later chairman of the board of 
directors, the organization contained a core of enthusiastic adven- 
turers who would never take "no" for an answer. These men believed 
that their immediate future lay in making parts for the automobile 
industry. After 1921 the company was able to capitalize sufficiently 
upon the great growth of automobile demand to remain in business. 
Lack of strong backing among the directors prevented the active 
management group from expanding the company as it desired. To 
most of the directors and principal stockholders the Hutter Com- 
pany was a business hobby rather than a main business interest. The 
result was that in 1938 the company was a relatively small concern 
making automotive and aircraft engine parts, and carrying on ex- 
perimental work on a small scale. 

During the period from 1921 to 1938 there was some turnover in 
the management group. A few men retired because of age, others 

8 



MUTTER COMPANY 9 

sought better business opportunities, and several young men who 
shared the adventurous spirit of the founders joined the company. 
These men developed new products which were expected to appeal 
to the automobile manufacturers and air-transport companies. They 
worked on other products in cooperation with the Army Air Corps 
and Army and Navy Ordnance. These government agencies, how- 
ever, had small appropriations for such work during this period, and 
little money was available in the company itself, with the result that 
many items got no further than the drawingboard stage, only a few 
were perfected to experimental state, and fewer still were mar- 
keted, and those only in small volume. Partly in order to save money 
for developmental work and partly because the small scale of op- 
eration did not require elaborate controls, the company had kept 
at an irreducible minimum the expenses for cost accounting systems, 
operating statistics, budget procedures, and the like. According to 
Mr. Hall, in 1938 there were few useful facts on operations or costs 
available for management use. Such was the general condition of the 
company before World War II began. 

Expansion in World War II 

After Munich, the tempo changed for the Hutter Company. Both 
armament orders from Europe and the defense program of the 
United States increased the sales of the company. The inherent value 
of the past developmental work in its relation to the war became 
evident, and the directors decided to expand on a large scale. This 
action required new financing. To assist in this undertaking, the di- 
rectors elected Mr. Daniel Hall to the chairmanship of the board 
and made the position a full-time one for the period of the emer- 
gency. 

Under the pressure of the defense and war programs, the Hutter 
Company grew rapidly. The company increased the number of 
plants from two to fifteen, and old plants were expanded. The em- 
ployed personnel increased more than fortyfold. Old management 
was spread thin, promotions were rapid, and many new employees 
at all levels of management and supervision had to be recruited from 
peacetime industries. Both the chairman and the president agreed 
that it took from December, 1940, to April, 1944, for the full ex- 
pansion to bear fruit. It was in April, 1944, that production reached 
its peak. By that time, organizational relationships w^ere reasonably 



10 NATURE OF THE CONTROLLER FUNCTION 

well established and most of the "bugs" were out of both products 
and organization. In the opinion of several vice-presidents, most 
personnel were proud of results to date, even though they were 
somewhat weary from the stresses and strains of organization and 
reorganization at various levels. 

Daniel Holl—Choirmon of the Board 

Hall had long been a stockholder and director of the company. 
He was a close personal friend of Mr. Parsons, the president, as well 
as of several of the vice-presidents, and had served in the Army with 
some of them in World War I. Since he wanted to aid the defense 
and, later, the war effort, he believed that he could do so by accept- 
ing the chairmanship of the board. He therefore retired from his 
banking connections in a large midwestern city and joined the Hut- 
ter Company on a full time basis in 1940. According to Parsons and 
several of the vice-presidents, Hall, who was 50, had a striking per- 
sonality. His associates admired his keen mind, his capacity to pene- 
trate to fundamental problems and issues promptly and effectively, 
and his willingness to back with all his resourcefulness and whole- 
hearted support any idea that appeared to make the company func- 
tion more effectively. He was respected by everyone and, though 
his suggestions were never taken as "orders" except when so worded, 
nearly all executive personnel weighted heavily any comments or 
suggestions from Hall because their experience with, and analysis 
of, his suggestions so often verified his wisdom. In his relationships 
with other executives Hall never revealed excessive confidence in 
his own thinking, nor did he often make formal suggestions. The 
principal way in which he induced subordinates to act was by ask- 
ing and continuing to ask penetrating questions until he received 
thoroughly thought out answers. According to one vice-president. 
Hall ordinarily conveyed an impression of confidence in his sub- 
ordinates when he interviewed them on policy or operating matters. 
They freely admitted to each other the uneasiness which Hall's 
questions often caused. In the light of this background, all of those 
who were concerned in 1946 gave serious consideration to Hall's 
proposal to merge three departments as outlined below. 

Hall's activities in connection with his position as chairman of the 
board included public relations, relations with the government on 
financing of expansion, review of general policy matters with the 



MUTTER COMPANY 11 

president, monthly review of operating results, and corporate finan- 
cial problems. He wanted a strong operating organization and lie 
conferred frequently with the president on operating matters. It was 
necessary, however, for one of them to give more attention to finan- 
cial requirements and Hall had accepted this division of responsi- 
bility. He thus had a deep concern over the company's financial 
budgets and plans. Hall and Parsons cooperated effectively on these 
and other matters. The mutual regard which they had for each 
other's ability and their close cooperation and discussion of prob- 
lems resulted in an appearance of singlemindedness. Any major 
differences which they may have had were not apparent to subordi- 
nate officers. The major burden of policy formulation and execution 
was left to Parsons and the vice-presidents on his staff. 

Eugene Parsons— President 

Mr. Eugene Parsons, the president, had been associated with the 
Hutter Company from the beginning. According to Hall, Parsons 
had imagination, and was quick to grasp new scientific ideas as well 
as to see their long-run implications to the technology of the com- 
pany and the industry. He was an innovator. Some said he liked to 
play with new gadgets. Hall attributed the success of the company 
during World War H to the daring innovations in products which 
Parsons was willing to make in cooperation with the armed services. 
Parson's ideas were often far ahead of those of his vice-presidents. 
They thought some of his ideas fantastic, and his ever-present drive 
to force them to convert ideas into real products— tested in use in 
"much too short" spans of time— often irritated them. They had diffi- 
culty at times in understanding what he wanted, and sometimes 
they had a tendency to resist change. They felt insecure in their 
positions when Parsons was pressing hard for the production of a 
product on which the technical problems of production presented 
formidable obstacles. They found it hard to explain to Parsons wh\' 
an idea was "impractical" from a production point of view. He did 
not like to take "no" for an answer without a trial. His conception of 
a "fair try" was considered exceptionally arduous by his subordinates. 
If the organization really tried to make a product or change a process, 
and failed, Parsons was willing to face the facts and give it up, turn- 
ing to some other solution. As a result of this drive and determina- 
tion to get the job done, the "impossible" was often accomplished; 



12 



NATURE OF THE CONTROLLER FUNCTION 



sometimes, to be sure, at the cost of a subordinate who did not make 
good. 

According to Hall, many of the vice-presidents were afraid of 
Parsons. Nevertheless, most of the time. Parsons expressed himself 
in a most friendly manner. This characteristic, added to the satisfac- 
tion which arises in an organization from accomplishing the seem- 
ingly impossible, brought considerable personal loyalty and affection 
to Parsons from his vice-presidents and subordinate executives. 

Orgon'izaf ion— 1945 

The key top management personnel and the heads of departments 
affected by the problem presented herewith are shown in the or- 
ganization chart in Exhibit 1. Additional information about the exec- 
utives follows. 



Hugh Walton— Executive Vice-President. Mr. Hugh Walton as- 
sisted Parsons and acted for him in his absence. Walton followed op- 
erating details more closely than Parsons, thus freeing the latter for 
broad policy-making functions. Walton tried to reduce the amount 
of work for Parsons by making those policy and operating decisions 
that flowed naturally from existing understandings between the two 
of them. Where there was general agreement among the vice-presi- 
dents upon a policy or operating plan, Walton approved it unless it 
was a matter which he knew to be of personal interest to Hall or 
Parsons. 

EXHIBIT I 

: Organization of the Hutter Company 



Board of Directors 
Daniel Hall - Chairman 



President -Eugene Parsons 
Executive Vice-President- 
Hugh Walton 



Treasurer's Office 
Clinton Straight - Treasurer 
Robert Bacon - Assistant 
Treasurer 



Administrative Vice-President 
Richard Miller 



Public Relations 
Vice-President 



Industrial Relations 
and Personnel, 
Vice-President 



Statistics Office 
Joseph Thorp. Manager 



Planning Department 
James Harwood, Manager 



Production 
Vice-President 



Purchasing 
Vice-President 



Sales 
Vice-President 



15 Plants I 



Domestic 

Sales 

Manager 



Export 

Sales 

Manager 



HUTTER COMPANY 13 

Walton was a man of about 50 years of age who had wide ex- 
perience within the Hutter Company. He had grown up in the 
production end of the business, having been manager of one of the 
domestic plants. At one time he was in charge of the export depart- 
ment and he had also served for a brief period as vice-president in 
charge of production. His versatility was indicated by the fact that 
he had also been in charge of public relations just before his election 
to the post of executive vice-president. He was particularly adept at 
maintaining good public relations for the company. He was socially 
successful, and in this capacity was a credit to the concern, so much 
so that he was criticized in the cloakrooms, corridors, and lunch- 
rooms. Some people questioned whether he really had as much 
ability as his position implied. According to one of the vice-presi- 
dents, Walton did not always appear to be certain of his relationship 
either to the president or to Hall and was a man who would let well 
enough alone when he could. Some of his subordinates believed that 
he was slow to make decisions and in that respect was an impedi- 
ment to progress; others felt that this slowness in some instances had 
been a tremendous protection to the company because it had thus 
avoided headlong and probably incorrect decisions. 

Clinton Straight— Treasurer. Since the financial problem was of 
so much interest to the top officers, the treasurer was shown on the 
chart reporting directly to the president and executive vice-presi- 
dent. The treasurer's office was charged with the supervision and 
administration of all budget and financial functions. It was expected 
( a ) to outline a financial program which would enable the company 
to carry out its current marketing and production plans and to fi- 
nance its longer term capital requirements; (b) to prescribe the kind 
of budgeting and accounting organizations needed in the various 
offices and plants, and to outline systems, methods, procedures, and 
necessary financial reports required of all parts of the company; (c) 
to conduct supervisory activities for compliance with the above 
mentioned methods and policies; and (d) to direct the audit func- 
tions of the company. 

Clinton Straight, who was treasurer, was a wealthy man of 50. 
Having married well and invested and speculated successfully, he 
was proposing to retire to his country estate after the war and en- 



14 NATURE OF THE CONTROLLER FUNCTION 

gage in the breeding of race horses. He prided himself on the fact 
that "the business did not get him down." 

Straight beheved in decentraHzation and claimed that he prac- 
ticed it. He established a financial office under a manager in each 
plant as well as in the export and sales departments. These man- 
agers were under the line control of the head of the department or 
plant which they served and provided the managers and other 
executives with such reports as they requested. The organizations 
under these plant or department finance managers recorded ex- 
penses in accordance with a home office manual of expense classifi- 
cations and related these expenses to major budget classifications or 
capital appropriations approved by the board and the president. 
Furthermore when requested by plant managers or department 
heads the managers kept cost accounts and made cost analyses. 
There was no uniform cost system employed in all plants. In 
Straight's opinion, he did not interfere with the operation of the fi- 
nance office in each plant or department. He was satisfied that the 
procedures and methods prescribed by his office insured that all 
cash, incoming and outgoing, was properly accounted for and 
protected. 

Richard Miller— Administrative Vice-President. During the war 
the burden on top management had become so great and so many 
consequential policy and operating decisions had to be made that 
the company created the position of administrative vice-president. 
This position was filled by Richard Miller. He was a likable man of 
55 who had been with the company for 25 years. He relied upon the 
vice-presidents below him to take the initiative in drawing up policy 
proposals and preparing operating plans. He reviewed their pro- 
posals to make sure that they had been broadly considered; for in- 
stance when the vice-president in charge of sales proposed a plan 
for the modification, elimination, or addition of a new product, he 
checked to determine whether the effect on production, purchasing, 
personnel, and public relations had been adequately studied. Much 
of his time was given to verification of such facts and to conferences 
with vice-presidents or their representatives to resolve differences 
of opinion. After Miller's review of major plans and proposals, Exec- 
utive Vice-President Walton or President Parsons took the neces- 
sary action to approve or revise plans, after which the domestic 



MUTTER COMPANY 15 

plants, sales, and export departments proceeded to operate accord- 
ingly. Interested vice-presidents or department heads were supposed 
to review their operations and the operations of the domestic plants 
and sales departments and to prepare summaries of results for Miller. 

Joseph Thorp— Manager, Statistical Office. As the expansion pro- 
gram progressed, the four top officers, Hall, Parsons, Walton, and 
Miller, realized that the intimate and firsthand personal knowledge 
of operations and people which had been an important element in 
their control of the company when it operated on a small scale would 
diminish as the scale of operations expanded. They would be re- 
quired to substitute less personal methods of control and to rely to 
a greater extent on summary statistical, cost, and financial data, and 
formal operating reports in order to follow operations. Also they 
would have to delegate more authority and responsibility than be- 
fore to the vice-presidents, department heads, and plant managers. 
Standards of performance, which were intuitively understood in the 
small-scale organization consisting of men who had worked together 
many years, would have to be made more explicit and objective in 
the future in order that new management personnel from other in- 
dustries could be absorbed and could become effective. 

For the above reasons in 1942 the officers decided to expand a 
small statistics section in the production department into a statistical 
oflfice serving all parts of the company. The new office reported to 
Miller, the administrative vice-president. This department was 
placed at a high level in the organization for the purpose of convey- 
ing to all executives an appreciation of its importance to top manage- 
ment. This department was to render service to all executives and 
departments and at the same time it was not to be subordinated to 
the interests of any one department. 

The statistical office was to be a fact-finding and fact-analyzing 
agency capable of supplying executives and supervisors the data 
needed for better control and forward planning. The manager was 
told to collect, revise, and consolidate the operating facts originating 
at the lowest levels of operation into summaries and analyses ap- 
propriate for each of the levels of supervision. Like many other such 
ventures, this office was faced immediately with nonstandard statis- 
tics, different definitions and classifications, and some personal op- 
position, at both high and lower levels of management, to the notion 



16 NATURE OF THE CONTROLLER FUNCTION 

of standardization, summarization, and comparison of the operating 
statistics of separate plants or departments. 

Joseph Thorp, the manager of the office, was an aggressive leader 
who sensed the importance of the contribution of his office to good 
management throughout the company. He induced the management 
to establish similar functional offices in each plant and department 
and he assisted these units in the procurement of qualified personnel. 
Thorp indoctrinated these executives at plant levels with his phi- 
losophy of service to management and urged them to become ag- 
gressive leaders in their own organizations. These men were on the 
staff of department heads or plant managers from whom they re- 
ceived orders and to whom they tried to sell a more effective use of 
statistics by management. 

In Hall's opinion, it was at least a year and a half after the statisti- 
cal office was established before major resistance to its efforts by 
executives and supervisors was overcome. The latter, at plant levels, 
tended to resent "home office" interference in management methods. 
They did not like to be told what reports to use; they were not sure 
whether the reports were to help them or to highlight their defi- 
ciencies. Both at the home office and in the plants there was an initial 
resentment by line officers who objected to "being told" by staff offi- 
cers what facts they should use and how they should interpret these 
facts in carrying out their own defined responsibilities. Whenever 
there were explosions on such questions that got as far as Hall, he 
nearly always supported Thorp and his assistants. 

James Har wood— Manager, Planning Department. In carrying 
out his duties, the administrative vice-president had the assistance 
of a planning department. During the expansion there had been 
serious breakdowns in coordination between functional departments 
such as sales, production, purchasing, finance, and . personnel, and 
schedules of operations were not well enough synchronized. There- 
fore late in the expansion program the planning department was 
established to insure that the various aspects of the expansion pro- 
gram were coordinated and properly scheduled and that all de- 
partments and plants kept in step in the same sales program. When 
this program was revised as a result of changes in the orders of the 
government or industrial customers, this department was expected 



HUTTER COMPANY 17 

to watch the follow-up of these changes in the operating plans of the 
company. 

This department worked out planning procedures which were 
widely used throughout the organization to keep the production 
plans in balance with sales estimates. The personnel of the depart- 
ment were adept at showing other departments and supervisors how 
to plan the flow of material and personnel, and how to plan the time 
for manufacturing products and their components to the schedule 
of deliveries for products. The department had no policy-making or 
line operating functions and had no counterpart in the domestic sales 
department or in the plants. It was expected to make continuous 
studies of the status and progress of company operations in terms of 
stated plans. 

James Harwood, manager of the planning department, had a staff 
which was expertly trained. They endeavored to cooperate with all 
home office departments in the solution of their operating and plan- 
ning problems. The aim of the planning department was to help the 
organization as a whole to succeed. When the department had an 
idea for the improvement of an operating method or a planning pro- 
cedure it submitted the idea to the vice-president or department 
concerned. 

The Current Problem 

Need to Reorganize 

In November, 1945, Mr. Daniel Hall was examining certain pre- 
liminary budgets for the year 1946. He was very much dissatisfied 
with them. They seemed too large, not particularly well founded on 
realistic operating plans, and were apparently "costed" on fallacious 
data. He understood that the budgets had been prepared in a hurry 
following the end of the war with Japan, and that some of the esti- 
mates had been developed by inexperienced personnel. This latter 
condition was the result of the rapid decline of sales in the company, 
the necessity of layoffs, and the accompanying tendency of skilled 
workers and executives to leave the firm and go back to the busi- 
nesses with which they were formerly associated. 

Mr. Hall believed the Hutter Company was bound by events to 
shrink again in size after World War II. Therefore he thought it 
advisable to formulate longer-run plans and objectives as quickl)^ 



18 NATURE OF THE CONTROLLER FUNCTION 

as possible, to profit from the experience gained on a large scale dur- 
ing the war, and to rebuild the organization to the new lower level 
of operations in the shortest possible time. In connection with these 
necessities Mr. Hall prepared a memorandum proposing expansion 
of the treasurer's office. 

Hall's Memorandum 

Mr. Hall's memorandum on expansion of the treasurer's office, was 
as follows : 

As a result of the end of the war with Japan and the cancellation of govern- 
ment contracts we have entered the cycle of sharp contraction, of reduction of 
expenditures, and of competition of departments or projects for the limited 
funds and personnel which we can now make available. Our business increased 
in complexity during the war, and the outlook is for greater complexity in peace. 
We are requiring a more accurate selectivity of product projects than ever 
before and a more intense follow-up of the application of limited funds to 
such projects. In short, we must be sure that every dollar allocated to a capital 
expenditure goes to the most needed project, and we must get a full dollar's 
worth as well out of every dollar expended in the current operating program. 
This requirement calls for the best business management, not only to provide 
basic facts for policy decisions but to follow through on such matters. 

Sound practice requires the Hutter Company to develop further a plan 
which can provide organized and completely coordinated operating and capital 
expenditure budgets. This plan will require an organization which has a thor- 
ough knowledge of the facts from a practical, analytical, and not a bookkeeping, 
angle. We have made much progress during the war in adjusting our business 
methods to those of a larger-scale organization by adding the statistics office 
and the planning department. We need further to improve our expense controls 
and cost accounting procedures, and we should make much more careful 
analyses of needs than we were able to make during the war period. I believe 
the solution of this major problem lies in the merger of the office of the treasurer 
with the two other departments mentioned to form a new unit entitled Office 
of the Treasurer and Controller to be headed by a vice-president. In my opinion, 
this new office should report directly to either the president or the executive 
vice-president. 

The general functions of the new office would include the following duties: 
(a) to organize and unify the operating plans of the various departments and 
factories into a single master budget program; (b) before submitting that 
program to the president and the board of directors for approval, to check the 
phasing of the various parts of the operating budget; (c) to analyze current 
actual performance against the scheduled standards of performance used in the 
preparation of the budget; (d) to perform functions similar to a, b, and c for 
capital expenditures; (e) to make continuous studies in cooperation with depart- 
mental and factory agencies with respect to operating standards; (f) after 
approval by the board of the master budgets, to allocate funds among various 
activities and supervise the accounting and auditing systems in connection 
therewith. 

\. 



MUTTER COMPANY 19 

In my opinion the steps outlined above should result in a more orderly- 
development of our budgets and make possible more expert and persuasive 
presentation to the board of directors. Some saving may be anticipated from the 
simple combination of such functions. 

Reception of Holl Proposal by Subordinates 

Hall was planning an extended trip combining some vacation with 
visits to certain key plants. Before leaving he had an informal talk 
with Parsons about his proposal. He gave Parsons the written memo- 
randum because "it gives a succinct statement of my views on an 
important problem." Parsons told Hall that he was in general agree- 
ment with him and suggested that Hall's memorandum be given to 
Mr. Hugh Walton, executive vice-president, for further review, 
analysis, and ultimate comment. 

Walton s Reaction, Mr. Hugh Walton received Hall's memoran- 
dum from Parsons with considerable misgiving. He was not sure 
what it was intended to convey. He realized that Mr. Parsons, who 
had not analyzed the matter at all, was favorably disposed to Hall's 
suggestion. Richard Miller, the administrative vice-president, also 
thought it was worthy of careful study. Later in the day Mr. Walton 
was in Mr. Hall's office and Hall asked, "What do you think of my 
memorandum?" Walton replied, "Your memorandum places too 
much emphasis on planning and coordination and builds up the 
position of the proposed new vice-president so much that I can't see 
why I'm needed in the company any more." 

Mr. Hall later explained that he had been amused by this im- 
mediate reaction and had suggested that Walton reread the memo- 
randum. There was nothing in the memorandum, said Hall, which 
was designed in any way to reduce the importance of the president, 
the executive vice-president, the administrative vice-president, or 
any of the senior members of top management. Hall explained to 
Walton that instead of weakening the position of any of the top ad- 
ministrators, the proposal was designed to strengthen their control 
over the company's operations and to insure that a dollar's worth of 
value was received for every dollar expended. 

Report of Special Committee, Mr. Walton sent copies of Hall's 
memorandum to the administrative vice-president and to the other 



20 NATURE OF THE CONTROLLER FUNCTION 

vice-presidents shown on the home office organization chart, and 
asked for their comments. Each of them expressed a desire to study 
the matter further and made no additional comments either for or 
against the project. Thus, the matter came back to Mr. Walton for 
further action. He appointed a special committee consisting of rep- 
resentatives from the office of each of the vice-presidents and in- 
cluded in addition, representatives of the treasurer's office, the plan- 
ning department, and the statistics office. After a month's study this 
group turned in a report which was considered wholly unsatisfactory 
by Mr. Walton. The group had not made a penetrating analysis of 
the proposal, and obviously did not want to get into organization 
politics with which this project apparently was being "tarred." A pe- 
riod of two months had elapsed since Hall made his proposal to 
Parsons. Both Hall and Parsons were asking Walton what results he 
had obtained and what his final recommendation was going to be. 

Walton felt that he had to reach some kind of conclusion, and 
therefore he called upon Barton James to write a report on the situ- 
ation, recommending to what extent, if any. Hall's recommendation 
should be accepted, and indicating what steps should be taken to 
make any of James' proposals effective. 

Study by Barton James 

Background "^ 

Barton James was well known to many of the officers of the Hut- 
ter Company. He had been loaned to the Hutter Company during 
the war to assist it in its expansion program. He had started work in 
the summer of 1941 and left October 1, 1945. During that time he 
had brief periods of service with the purchasing and the production 
departments. He was a close personal friend of the vice-president 
in charge of sales, was well acquainted both socially and profession- 
ally with the treasurer and the manager of the statistics office, and 
he had had some business contacts with the head of the planning 
department. He had also worked at one time or another as a special 
assistant to the administrative vice-president and to the executive 
vice-president. He was well known to both Hall and Parsons, and 
his views had always been given consideration by them. Because of 
^lis service as special assistant to the administrative vice-president, 
he had experienced many business relationships with the other vice- 



MUTTER COMPANY 21 

presidents in the home office and knew personally a number of the 
plant managers as well as the domestic sales manager. None of these 
officers had ever considered James a rival in the organization because 
they knew he was on loan from another company. On his retirement 
the officers had given him a farewell banquet, in which considerable 
personal regard for him had been expressed. 

James hesitated to accept the request of Mr. Walton to write such 
a report because he knew the organization was in a state of flux and 
was likely to continue so for another year. He did not wish to take 
sides in organization arguments, and he was of the opinion that 
writing reports on this type of problem was not a particularly good 
use of time; if he were working within the organization, he thought 
that he could help resolve issues such as stated in Mr. Hall's memo- 
randum, but he had little faith in outside suggestions on inside prob- 
lems. A number of executives spoke to him about undertaking the 
assignment, and expressed their confidence in his unbiased judg- 
ment. Walton asked the president of James's company to lend him 
for a short period to the Hutter Company. Reluctantly James ac- 
cepted the job. 

A brief account follows of his conferences prior to the time he sat 
down to write his report. 

Preliminary Conference with Walton 

After accepting the assignment James had a brief conference with 
Walton to talk about budget planning. Neither wanted to become 
too specific at this point but they agreed that Hall and Parsons prob- 
ably would be satisfied with a statement of the process which can 
be described in a general way as follows : 

The vice-president in charge of sales, working with the other functional 
vice-presidents and with the export sales department and the domestic sales 
manager, should approve each year an estimate of sales by products. This 
would be agreed upon first in a merchandising committee, which might include 
the domestic sales manager, the export sales manager, the purchasing agent, 
and the manager of the statistics office. Their estimates should be arrived at 
through studies of general business trends with adjustments for particular 
geographic conditions and particular industries which affected the company's 
market. Estimates also should be based on sales by customers or customer classes 
for the last five years, projecting to these sales the effect of any merchandise 
changes or additions to lines. The committee's judgment with respect to these 
two estimates would become the final estimate submitted to the vice-president. 
After approval or revision of this estimate all master plans were to be based 



22 NATURE OF THE CONTROLLER FUNCTION 

upon it. A finance committee of the board of directors, working closely with 
the vice-president in charge of sales, the vice-president in charge of production, 
the vice-president in charge of purchasing, and the treasurer, might set in- 
ventory limits on various types of finished goods and work in process. Efforts 
should be made to schedule production on as even a basis throughout the year 
as possible, giving due weight to variation in sales and allowed variation in 
inventory limits for various seasons of the year. 

The principal job of the enlarged treasurer's department would be to see 
that the master plan so generally conceived was worked out on a broad basis 
at the home office level and on a more detailed basis in the departments and 
plants. Thus, estimated deliveries from production and some corresponding 
factor for sales departments would become the basis of properly time-phased 
requirements for personnel, raw materials, purchased parts, and other services 
required in the sales, production, and office organizations. Presumably the 
volume flowing through a department would be the basis upon which budgets 
were determined. To the estimated volumes by time periods, cost factors and 
purchase prices could be applied to arrive at financial estimates. This process 
required good planning of flows and presumed the knowledge and use of good 
operating standards. 

James next talked with Clinton Straight, the treasurer, and Robert 
Bacon, the assistant treasurer. 

Conference with Clinton Straight 

Mr. Straight emphasized in his interview that he was planning to 
retire within a month and was therefore not a candidate for the en- 
larged position of treasurer and controller with the title of vice- 
president. He stated that he could not honestly recommend Mr. 
Bacon, the assistant treasurer, for the vice-presidency but he did feel 
that Bacon was a worthy successor for the limited functions of the 
present treasurer's office. 

During his period of service with the company he thought he had 
established a basically sound underlying internal auditing, account- 
ing, and financial organization. He did not believe in prescribing 
systems for department heads and managers. That is why he had 
long favored decentralization of control. His internal audit organ- 
ization checked on the adequacy of the procedures set up by the 
department and plant managers for safeguarding and recording 
assets, and on the observance of these procedures and others that 
the home office had to announce on a company- wide basis. In carry- 
ing out the budget functions assigned to his office, he had taken a 
relatively passive interest. He assumed that the figures presented to 
him for budget purposes by the managers of plants were based on 



MUTTER COMPANY 23 

sound data for volume requirements and unit cost. It was with this 
view that Hall apparently expressed disagreement. Nevertheless, 
Mr. Straight doubted the wisdom of expanding the treasurer's or- 
ganization by merger because it would upset existing relationships 
and would, in his opinion, inevitably lead to increasing the control 
of the home office over the subordinate department heads and plant 
managers. This possibility he regarded as a mistake, and he was 
certain, moreover, that the oldtimers who held these positions would 
vigorously oppose such encroachment on their authority and respon- 
sibility. He thought that if Hall's proposal meant that the top man- 
agement was not satisfied with the domestic sales manager and the 
domestic plant managers they could solve the problem better by 
getting new managers than by complicating the control and organ- 
ization setups. 

Conference with Robert Bacon 

In his talks with Mr. Bacon, James found that Bacon also doubted 
the wisdom of a merger of the three offices, but for entirely different 
reasons. He felt that the aggressive efforts of the statistics office had 
caused friction, and joining up with such an office would tend to 
weaken his own prospective influence within the Hutter Company. 
He was convinced, however, that there was need for better manage- 
ment on the part of the heads of domestic plants, the domestic sales 
manager, the various vice-presidents and their supporting staffs. In 
Bacon's opinion, these men had all the facts they now needed from 
the three offices separately organized. The problem was to get 
them to use the facts they had. Too many of the executives, in his 
opinion, were men of the old school who did not realize that "times" 
and the scale of company operations had changed. When asked who 
in the company would take the leadership in improving the capabil- 
ities of the executives, he had no answer. He more or less implied 
that it was the problem of Mr. Miller, the administrative vice-presi- 
dent and Mr. Walton, the executive vice-president. He pointed out 
without being asked that Miller was quite good in listening to and 
seeking out facts for reaching company decisions, but that Walton 
was notorious for making policy and operating decisions on insuffi- 
cient facts and without adequate consultation with the vice- 
presidents. 



24 NATURE OF THE CONTROLLER FUNCTION 

Conference with Joseph Thorp 

When James called upon Joseph Thorp, the manager of the sta- 
tistics office, he found an enthusiastic supporter of Mr. Hall's pro- 
posal. Thorp thought the move should be made at once. He had no 
desire to be the head man, and he thought it most inadvisable to set 
up the three offices as separate entities within the new vice-presi- 
dent's office. He wanted to start reorganizing from the bottom, and 
suggested the possibility of organizing divisions within the new 
office such as budget planning, budget analysis— comparison of actual 
expenditures with budget— funds control, statistical analysis, a plan- 
ning section, and the like. He thought the organization should report 
to the administrative vice-president instead of to the executive vice- 
president. He favored organizing corresponding offices in the domes- 
tic sales department, the export department, and the various plants, 
and he wanted the home office to have complete technical supervi- 
sion over these offices, their general procedures, and certain standard 
reports required by the home office. These offices should, he thought, 
be under the line supervision of the particular plant or department, 
but personnel would be selected and trained by the home office or- 
ganization. He believed that merging the three offices and reorgan- 
izing the office internally would give the managers at lower levels in 
the organization, as well as top management, a more lucid picture 
of the operating results and problems of the company. It would be 
easier for such a technical organization to cooperate with the 
methods men in the plants and the office managers of other depart- 
ments in working out and checking upon standards of performance. 
The general pattern of tight control from top down to the lower 
levels of organization, implicit in the views of the head of this de- 
partment, was in sharp contrast to the views of the treasurer. 

Conference with James Norwood 

Mr. James' next interview was with the manager of the planning 
department, Mr. James Harwood. He concurred in some of the 
statements made by the treasurer and the assistant treasurer. He 
felt that there was a great need for better coordination and financial 
planning, and thought also that it was very necessary to develop 
better methods both in the factory and in the offices, and to tighten 
standards of performance. He agreed with Mr. Bacon on the old- 



MUTTER COMPANY 25 

fashioned approach of many of the department heads or plant man- 
agers and some of the home office staff. He had grave doubts 
whether any improvement could be made, but thought the plan 
was worth a trial. He realized that he had no chance of becoming 
the new vice-president in charge of the office of treasurer and con- 
troller. He urged James to point out in his report the importance of 
the right kind of person for that position. He had in mind one of the 
abler managers of one of the domestic plants, Mr. Stanley Poole. 

Harwood made a strong argument for the suitability of Stanley 
Poole. Poole had served in the sales department as a young man and 
had served in the export department in Asia. At one point he had 
been an assistant to the vice-president in charge of sales in the home 
office and at present he was manager of one of the larger domestic 
plants. Harwood admitted that Poole might not regard as a promo- 
tion the change from the line control of a plant to a staff position in 
top management. However, Poole was considered very loyal to the 
organization. Moreover, he prepared excellent plans for operations 
and usually submitted good budgets as well. He had a broad con- 
ception of policy matters, and he knew how to dig into detail when 
that sort of work was required. He was also a man with whom 
Harwood would like to work. James thought that Harwood meant 
by this statement that he would like to be the principal assistant to 
Mr. Poole in case Poole were made vice-president. 

Conference with Richard Miller 

Mr. James next interviewed Richard Miller, administrative vice- 
president. He had had so much trouble during the readjustment 
period getting coordinated plans from his vice-presidents, depart- 
ment heads, and plant managers, that he was automatically for the 
proposal and felt that it would assist him greatly in carrying out his 
responsibility. He suggested that the job of top management was 
simply too great for the four men now charged with it and they 
needed the expert assistance of the enlarged office of treasurer and 
controller. He suggested the possibility that the general collection of 
reports and facts from subordinate plants or departments might be 
accomplished without merger by the statistics office, now under his 
control, and that the analytical functions of that office might be com- 
bined with those of the planning department and the treasurer's 
office to form the new organization. He urged that the new office 



26 NATURE OF THE CONTROLLER FUNCTION 

report directly to the executive vice-president and not to him. He 
beheved that an assignment of the enlarged office to the executive 
vice-president would increase its importance in the home office, in 
the minds of managers of the domestic plants, and of the domestic 
sales manager. 

Other Conferences 

James also talked to the vice-president in charge of sales and the 
vice-president in charge of production. These interviews produced 
nothing with which he was not already familiar from his previous 
contacts with the company, and served only to confirm his opinion 
that so long as the treasurer and controller functions were conducted 
in a manner to assist vice-presidents and the plant and department 
managers in the operation of the business, any plan would be ac- 
ceptable. However, if the proposed plan was designed to tighten 
controls on these officers and to lead to any diminution in their au- 
thority or policy-making responsibility, they were likely to be against 
it. 

The vice-president in charge of production suggested that the size 
of the proposed organization might be reduced if the treasurer's 
general functions were not included in the enlarged office. He pro- 
posed, as an alternative, taking the budget and accounting functions 
out of the treasurer's office and setting them up in a separate con- 
troller's office. Under his plan the treasurer would not report to the 
president and the executive vice-president but would be on a par 
with the other vice-presidents reporting to the administrative vice- 
president. The treasurer's activities would consist largely of respon- 
sibility for funds and investments. It seemed to be a matter of in- 
difference to the production vice-president whether the proposed 
controller's department should report directly to the executive vice- 
president or to the administrative vice-president, which would place 
him on a par with the other vice-presidents. Under this plan of the 
production vice-president, the controller would be the principal ad- 
visor or assistant on control matters to top management and would 
have the responsibility for the coordinated preparation of budgets 
throughout the company. The controller would be in charge of the 
development of standardized systems of accounts, budgetary pro- 
cedures, uniform statistics, cost accounts, and the like. By prescrib- 
ing the minimum essentials for accounting and statistical systems and 



^// 



^7/iV 



MUTTER COMPANY 27 

procedures he would provide the basis for uniform records on which 
analyses, comparisons between plants, and summarization of results 
depended. 

The vice-president in charge of sales raised a question in his in- 
terview regarding the advisability of making too drastic a change in 
existing organization during a period when outside events beyond 
the control of the company were themselves far-reaching in character 
and upsetting as well. 

From other talks with more than one vice-president, James learned 
that the company was pretty well organized as it was, and that with 
the reduced pressure on executives as a result of the end of the war, 
there should be opportunity for better coordination of activities and 
for better planning, budgeting, and setting of standards. In their 
opinions the recognition of the need for information for making 
decisions and the willingness to use it were probably as essential as 
any changes in organization. They pointed out, without prompting 
from anyone, that both the president and particularly the executive 
vice-president were sometimes remiss in not using the facts that were 
available. They could see some slight margin of advantage in favor 
of the modification of Mr. Hall's proposal suggested by the produc- 
tion vice-president because of the complete unification under the 
controller of the budget, comparison, and coordination functions. 
Nevertheless they seriously doubted the wisdom of establishing the 
proposed office unless the president and executive vice-president 
were willing to do two things: (1) assign competent personnel to 
the office, and ( 2 ) be informed regularly by it of the progress of the 
company and of any problems revealed by analyses of operations. 
They stated that James's report would be genuinely incomplete if 
he failed to discuss this matter. They argued, further, that James 
was risking his reputation if he failed to point out the extent to 
which the two considerations mentioned above affected the ultimate 
success of Mr. Hall's proposal or any modification thereof. 

Tentative Conclusions 

After completing these interviews and before writing his report 
James came away feeling that he had a choice among the following 
possibilities: (1) maintenance of the status quo; (2) complete en- 
dorsement of Hall's proposal; (3) some modification of Hall's pro- 
posal in accordance with suggestions made by different officers; or. 



28 NATURE OF THE CONTROLLER FUNCTION 

( 4 ) presentation of an entirely new plan. In view of the time when 
his initial report was due and the complicated political situation 
within the organization, he ruled out the fourth possibility. 

James considered carefully not only the conclusions to be drawn 
but also the manner of presenting them to Walton because he sin- 
cerely wanted to be helpful and felt that his problem was to decide 
what to say now that would make the most effective contribution to 
the long-run results desired by Hall and others. He planned to pre- 
pare a short report which he would discuss orally when he delivered 
it. At that time he might have an opportunity to discuss more points 
than could be put into a brief document. He intended to leave this 
short report with Walton and wanted it to contain those points which 
above all others he desired Walton to remember. He also believed 
that he should have ready a longer report, going into greater detail, 
to support the short report. 

James wondered whether he ought to bring out in the short report 
either of the following points : ( 1 ) the problem which top manage- 
ment faced in making able executives and supervisors still more 
effective by indoctrinating them in the use of a modern control 
philosophy; (2) the type of man required to do the job and the 
attitude he should take toward it and the other executives concerned. 

What, in your opinion, prompted Mr. Hall to issue the memorandum 
proposing expansion of the treasurer's office? 

What should Mr, James do now? 



ease 



ARGOSY CHEMICAL CO. 

Placing the Budget Function in the Organization 

This case involves a reorganization of the controller function by a 
newly appointed chief operating executive. More specifically, it is 
concerned with the establishment of a new office at the vice-president 
level, a primary duty of which was to be the direction and adminis- 
tration of the budgeting operation. 

"Another new vice-president— this time in charge of planning and 
control," groaned the manager of the industrial chemicals division 
of Argosy Chemical Co. 

"From the way I read his proposed duties and responsibilities, it 
sounds like the old job of Budget Director now promoted to the job 
of unofficial executive vice-president," said the vice-president of 
commercial sales. 

"What I can't figure out is what the controller's office is now 
supposed to do," was the controller's comment. 

"I thought the chief value of budgeting was not the budget itself 
but the examination of operating plans required in preparing a 
budget," came from an interested operating official. 

These comments were a few of the many being made about some 
organizational changes proposed for the Argosy Chemical Co. 

The Argosy Chemical Co. was a large chemical company engaged 
in the manufacture and sale of over two thousand chemical com- 
pounds ranging from bulk chemicals to consumer products sold in 
drugstores and hardware stores. Sales in 1954 totaled $148,000,000, 
and profits after taxes were $2,900,000. The company had fifteen 
plants in seven states with executive offices in Chicago, Illinois. 
There were five operating divisions, each headed by a vice-president 
reporting to the president. The president's office in Chicago had the 
following "staff" officers : vice-presidents of sales, manufacturing, in- 
dustrial relations, legal affairs, and a treasurer and controller. 

During the latter part of 1954 the new president of Argosy, 

29 



30 NATURE OF THE CONTROLLER FUNCTION 

Norman Bruton, undertook some organizational changes. Mr. Bruton 
was a graduate of a midwestern university and a graduate business 
school and had moved in as president with the principal directive of 
improving the profit showing of the company. 

One of the changes proposed by Mr. Bruton was the creation of 
the office of vice-president of planning and organization. One of the 
major duties of this office would be the direction and administration 
of the budget. The president strongly believed that a centralized 
effective budget procedure was one of the management tools for 
building a proHt, and hence should be a responsibility of a top officer 
reporting directly to the president. 

Mr. Bruton was aware that there was some question as to the 
wisdom of moving the budget function from the controller's office 
to a new and important position in the office of vice-president of 
planning and organization. He was contemplating what course he 
should take to gain acceptance of his proposed move. 

In thinking about this problem he made available to the case 
writer a series of comments which had been made about the budget 
and its place in the organization. 

Some of these notes and comments were: 

1. The head of the budget department should report to: 

a) Controller? 

b) Treasurer? - 
. c) President? 

d) Makes no difference? 

2. However you word it, can an officer responsible for planning and the 
budget be only a staff officer giving advice, not orders? 

3. What is a budget for? 

a) Is it a plan of operation reduced to the common denomination of 
dollars? 

b) Is it a way of measuring efficient performance? 

4. Do you have to have effective cost systems to have a budget? 

5. Who has final say on a departmental or divisional budget— the head of 
the department or division or the budget director? 

6. If the department or division manager has the final say over the budget, 
then is the job of the director of the budget one of scorekeeping? If so, 
isn't this the controller's job? 

7. Could all the confusion over the change be avoided and everybody satis- 
fied merely by dropping the use of the word budget and substituting the 
word planning? After all, every good company has to plan. 

In light of these comments, as Mr, Bruton, what would you do? 



ease 



THE BEARDSLEY CHEMICAL COMPANY 

Decentralization of Accounts Receivable 

In this case, the sales department requested a change In billing 
and accounts receivable procedures, which was refused by the ac- 
counting department. The issue of who decides accounting pro- 
cedures, and on what criteria, is raised. 

Introduction 

The Beardsley Chemical Company manufactured chemicals used 
in industry and patented household chemicals sold through hard- 
ware, variety, and department stores. Approximately 200 products 
were sold by the company. Its manufacturing plants were on the 
outskirts of Toledo, Ohio. Sales were channeled through division 
sales offices in the following cities, each division serving a surround- 
ing sales area: 

Cleveland Atlanta 

St. Louis Dallas 

Chicago Denver 

New York San Francisco 

Boston Seattle 

Present Account Receivable Procedure 

In 1945, the company centralized the account receivable record- 
ing, statement, and collection procedure, primarily in order to utilize 
fully a modern accounting machine installation. 

Under this procedure, orders for each sale were prepared in the 
division office on an IBM electric typewriter. Each invoice was 
numbered, and prepared in six copies. The original was sent to the 
customer, the other copies distributed as follows: 

2 copies to the warehouse or the factory for shipping purposes 

1 copy remains at the division office 

2 copies to the home office 

31 



32 NATURE OF THE CONTROLLER FUNCTION 

In the home office one copy was held awaiting notice of shipment. 
This copy was matched with a copy sent by the factory or warehouse 
showing date of shipment on it. The other home office copy was 
priced, extended, and federal excise taxes added, if applicable. This 
copy then went to the tabulating department, which recorded the 
following information on tabulating cards : 

1. Customer 

2. Date of order 
, 3. Division office 

4. Salesman ' 

5. Product 

6. Volume (cans, pounds, gallons, etc.) 

7. Dollars 

8. Excise tax, if any 

The tabulating cards then became the source of invoice billings, 
statements, accounts receivable ledgers, and various sales statistics. 

Customers were advised to remit collections to the home office. 

The company operated on a cycle billing procedure, so that 
severe month-end bottlenecks in accounting would be avoided. 
Each division, therefore, had a separate billing cycle in the home 
office routine. 

EXHIBIT I 

Statistics on Accounts Receivable 

1. Number of active accounts 60,000 

2. Total accounts having purchased within one year 110,000 

3. Average number of invoices per month 85,000 

4. Average biUing per month $24,000,000 

5. Total machine rental plus cost of supplies per year $115,000 

6. Total number of home office employees dealing full time on accounts 

receivable 215 

The company credit policies placed limits on credit extension 
based on size of account and unpaid balances in an account. This 
procedure was applied at the division level at the time orders were 
written. In order to supply the division office with the necessary 
credit information and other information relating to customers' ac- 
counts, a "history card" was used, showing customer's name, address, 
credit information, monthly billings, and collections. Each month 



THE BEARDSLEY CHEMICAL COMPANY 33 

before its particular billing time, each division sent its history cards 
to the home oifice, who prepared and mailed statements with copies 
of invoices attached, and posted the cards. After the particular 
billing cycle was completed, the history cards were returned to the 
division office. 

After the end of the month, various statistical reports were pre- 
pared and distributed. These reports were related to sales by volume, 
division, product, and salesman and were distributed— some to the 
division office and salesman, and others to the home office manage- 
ment. 

Criticism of Present Procedure and Request for Change 

In 1957, the sales department requested the accounting depart- 
ment to revise the present system in order to permit billing and state- 
ment preparation to be made at the division office. Reasons for this 
request were listed as follows: 

1. A great deal of customer good will was being lost through 
errors in billing or statement preparation— errors such as billing 
the wrong customer, improper credits, or improper inclusion 
of federal excise taxes. The sales department suggested that, 
since the division offices had contact with the customers and 
knew them, many errors could be caught or easily corrected. 
The sales department pointed out that the company had 344 
customers by the name of Smith; 14 were listed as R. A. Smith. 

2. Statistics which the division office and salesmen needed on the 
preceding month's business were slow in coming from the 
home office. Due to the pressure of other necessary month- 
end work, sales reports were going to division offices from the 
15th to the 25th of the following month. As a result of this 
delay, many divisions were trying to keep their own statistics, 
thus duplicating the work of the home office. 

3. The absence of history cards from the division office for about 
two weeks each month resulted in customer ill will. Customers 
would call in to learn their current balance and the division 
office could not advise them. This was particularly troublesome 
to customers who had been denied further credit because of 
a past due balance. 



34 NATURE OF THE CONTROLLER FUNCTION 

Review of Procedure 

The controller assigned his chief accountant to review the sales 
department request. The chief accountant, after review, estimated 
that an additional cost of over $60,000 per year would be involved 
if the decentralized plan were adopted. His estimate of additional 
cost is summarized as follows: 

Supervisors of accounts receivable and tabulating 
installations— 1 per division at $5,000 per year 
average $50,000 

Additional machine rentals 10,000 

Total $60,000 

The added rentals would be incurred, according to the chief ac- 
countant, because the large centralized accounting unit could not 
be reduced proportionately, as it was also used on manufacturing 
costs, payrolls, and other accounting work. One of the other jobs was 
the listing and preparation of dividend checks for 12,400 stock- 
holders. In this connection the chief accountant expressed concern 
over possible problems of the line and staff responsibility of account- 
ing personnel in division sales offices. 

Other costs which the chief accountant mentioned but did not 
calculate were increased internal audit costs if work were done in 
the division. 

Another disadvantage mentioned by the chief accountant was that 
the company sold to large industrial users who had plants in several 
division sales areas. It was pointed out that such companies wanted 
only one statement from Beardsley, and if there were divisional 
decentralization the companies might get three or four statements 
each month. 

Again, it was suggested that with divisional preparation of statisti- 
cal reports it would be difficult to get accurate reports for consolida- 
tion at the home office. 

Conference on the Issue 

At a joint meeting of sales and accounting personnel, a staff as- 
sistant to the vice-president of sales took issue with the chief ac- 
countant's calculations. The staff assistant reported that if a serious 



THE BEARDSLEY CHEMICAL COMPANY 35 

methods study were made he beheved the work could be done as 
cheaply in the division office. The preparation of statistical reports 
by division office personnel would be eliminated as a duplicate func- 
tion, thus saving some money. Further, the staff assistant commented 
that if the company accounting system was so inflexible that one 
change disrupted the whole system, then the whole system should 
be reviewed. The conference broke up without a decision being 
reached, each party promising to look further into the problem. 

If you were the controller how would you tackle this problem? 



case 



STRATFORD FOODS, INCORPORATED (I) 

Organization of the Accounting Function 

This case concerns itself with the problem of centralization vs. de- 
centralization of the accounting function in a company moving 
toward centralization of management. 

Introduction 

Stratford Foods, a large producer and distributor of nationally 
advertised food products had sales, in 1955, over $300,000,000; assets 
topped $100,000,000. Stratford had plants in 10 states, and sales 
offices in important cities all over the world. The company was or- 
ganized on a divisional basis, with line responsibility residing in 
division heads. Functional coordination was the responsibility of 
staff men at the home office in New York City. A portion of the 
former organization chart of the company showing line and staff 
responsibilities is shown in Exhibit 2. An organization chart of the 
controller's department is shown in Exhibit 1. 

History 

Stratford Foods, Inc., was formed from the consolidation and 
merger of about 13 individual food companies. The period of con- 
solidation and merger started in 1933 and continued through 1935. 
As companies were acquired, the growth of Stratford Foods, Inc., 
was so rapid that for many years each company continued to operate 
with the same personnel and policies as before acquisition. Several 
of the heads of companies acquired were men of strong will and 
could not have accustomed themselves to substantial directions from 
an executive office of the parent company. 

During the latter part of the 1930's and through the 1940's, staff 
organizations for each major function grew up in the General Offices 
in New York. Vice-presidents of manufacturing, sales, and research, 
operating as staff advisors in their particular function, became in- 
creasingly important as a part of the management picture. In the 

36 



STRATFORD FOODS, INCORPORATED (I) 



37 



late 1930's the separate corporations were dissolved and merged 
because of tax reasons existing at that time. The parent company 
controller's office assumed more responsibilities during this period. 
First the internal audit function, then budgets and methods devel- 
oped as a part of the controller's department. 

EXHIBIT I 

Organization of the Controller's Department 



Controller — — i 



General Accounting: 
Chief Accountant 

General Accounting 
Segregated P. or L. Acctg. 
Financial Analysis 
Statistics & Fixed Arrange- 
ments 
Tabulating Service 
Payroll 
Property Records 



Budgets, Expense Control 
and Cost Accounting: 
Asst. Controller 

Budgets -Methods, Summariza- 
tion and Analysis 

Income & Expense-Interpretive 
Analysis 

Cost Acctg.- Methods & Inter- 
pretive Analyses 



Methods, Credits, 
Audit follow-up & 
Acctg. personnel: 
Asst. Controller 

Methods- F>rocedures 
Forms & Installa- 
tions 

Credits-Analyses & 
Coordination 

Audit F/U 

Acctg. personnel 

Payroll Reconciliations 



Audits: General Auditor 

Regular & Special Audits 
of all Acctg. Records 



Taxes: Tax 
Manager 

General Super- 
vision of 
all taxes 



General Office Manage- 
ment: Office Personnel 
Manager 

Personnel Administration 
Health Service 
Office Regulations 
Office Layout, Service & 
Supply 



Division Controllers through 
Division Presidents 



Office Building Mgt. 
Building & Service 
Manager 

Maintenance- Building 
& Equipment 
Building Service 



Moves Toward Centralization of Operating Management 

During the early 1950's there was a major move toward centralized 
control of operating functions, eliminating the office of divisional 
president, and divisional sales and manufacturing staffs. Divisional 
sales offices were retained, and manufacturing staffs were assigned 
to specific plants or moved to the General Office manufacturing 
staff. Final steps in this centralization move were taken in the fall 
of 1950 with the elimination of the divisional management offices 
of the South Central division. 

Several factors were responsible for the centralization moves. 



38 



NATURE OF THE CONTROLLER FUNCTION 



First, the heads of subsidiary companies who had continued to 
manage these companies after acquisition were reaching retirement. 
Second, the company had begun a plan of standardizing products 
and placing products on a national distribution scale. Interplant or 
interdivision sales became common, involving problems of profit 
responsibility, billing procedures, and the like. Third, national dis- 
tribution of several products required centralized control of adver- 
tising, price, and promotion plans. Fourth, it was believed that con- 
siderable economy could be achieved in centralized management. 



EXHIBIT 2 

Organization of Stratford Foods, Incorporated 



PRESIDENT 
STRATFORD FOODS, INC 



PRESIDENT'S STAFF 



DIVISIONAL CHIEF EXECUTIVES 



OTHER 
STAFF 
MEN 



CONTROLLER 



VICE PRESIDENT 

IN CHARGE OF 

SALES 



VICE-PRESIDENT 

IN CHARGE OF 

MANUFACTURING 



RICHLAND 

CORPORATION 

CHIEF 

EXECUTIVE 



COLEMAN 
PROCESSING 

CHIEF 
EXECUTIVE 



OTHER 
STAFF 
MEN 



RICHLAND 
CONTROLLER 



RICHLAND 

VICE-PRESIDENT 

IN CHARGE OF 

SALES 



PLANT ACCOUNTANTS 



c^Tc; 



II 



OTHER 

CHIEF 

EXECUTIVES 



RICHLAND 
VICE-PRESIDENT 
IN CHARGE OF 
MANUFACTURING 



OTHER DIVISIONS 

(all have ORGANIZATIONS 

SIMILAR TO RICHLAND) 



I I ^^^11 



PLANT MANAGERS 



DIVISIONAL SALESMEN 



Accounting Problems Relating to Centralization 

In the latter half of 1956, the controller had come to the opinion 
that a serious study should be made of centralization of accounting 
work. Almost all accounting work, with the exception of consolida- 
tion, internal audit, budgets, and methods work, was done at the 
division level. 

In September, 1956, the controller requested his methods depart- 



STRATFORD FOODS, INCORPORATED (I) 39 

ment to make a study of the advisability of centralizing accounting 
work. In his letter to the methods department the controller said in 
part: 

The accounting department realizes its place in the organization. It considers 
itself a staff and a service organ. It believes that its job is to follow management, 
wherever it goes, and provide the best accounting material under those circum- 
stances. It realizes that the organization will not fit itself around the account- 
ing procedures— that the procedures are means, not ends. The executives must 
think along the lines of "what management wants," not "what management 
should want." The centralization changes in accounting, if any, must follow, 
not lead, management. 

The policy to be followed by the accounting department in making any 
change is that no already existing procedure will be changed unless there is a 
good reason for it. 

In January, 1957, the methods department made its report to the 
controller. A portion of this report is shown in Exhibit 3. A sum- 
marized organization chart under the proposed plan is shown as 
Exhibit 4. 

Analyze the proposed change and summarize your reaction to the 
plan, giving reasons. , 

What kind of profit and loss information would you plan to offer the 
vice-presidents of sales and manufacturing and the president? 



EXHIBIT 3 

Report on Partial Accounting Consolidation 
for Centralized Group 

I. Purpose and Nature of Study 

A study has been made of the extent and desirability of consolidating ac- 
counting, statistical, and credit functions of the centralized group should 
the necessity for computing profit or loss by divisions be eliminated, sub- 
stituting therefor a statistical merchandising profit or loss by area ofBces. 
The divisions included in this centralized group aie the Eastern, Cential, 
Southeastern, South Central. 
The major purposes of the study were as follows: 

1. To develop in tentative form a general plan under which the ac- 
counting and related functions would be accomplished, 

2. To determine the additional costs or savings in operating the plan 
developed, and 

3. To consider the manner in which various operational functions 
would be served by the Controller's organization under the plan, 
as compared to the present divisional basis of accounting. 



40 NATURE OF THE CONTROLLER FUNCTION 

II. The General Plan 

The first step in the study was to develop a tentative general plan for 
partial accounting consolidation of the centralized group, which is re- 
ferred to in the remainder of this report as the "General Plan." 

A. Certain Major Features of General Plan 

A few of the major features of the General Plan which are of special 
interest are summarized below: 

1. One general ledger is provided to contain the transactions now 
entered in the ledgers for the four divisions in the centralized 
group, and the General Office. The classification of accounts in the 
consolidated ledger will permit determination of profit or loss by 
activities, but not by geographical areas. The latter calculations 
would be accomplished statistically. 

2. Customer receivables would be maintained in area or branch 
offices. Employee receivables for plant employees would be kept 
in the General Office, but for area and branch employees at the 
aiea office, except thrift accounts which would all be centralized 
in New York. Construction ledgers would be centralized. Motor 
vehicle records (both asset and cost) would be a responsibility 
of the area office. 

3. The monthly closing and statistical analysis for the centralized 
group would be handled in the General Office. 

4. All reports or records originating in branch offices would clear 
through the area offices for audit and review before forwarding 
to the General Office for incorporating in the journals or other 
records. All accounting controls over plant operations previously 
performed in the divisional offices would be accomplished in the 
General Office. 

5. All journals (except for claims and purchased m.erchandise) and 
all expense ledgers would be kept on IBM tabulating equipment at 
New York. 

6. All Monthly Budget Reports would be prepared in New York. Ex- 
pense analysis for plant expenditures would be the responsibility 
of the General Office Budget Department, but analvses for ai'ea 
selling and administrative expenses would be continued in the area 
office. To this end, supporting papers to plant expenditures would 
be forwarded to New York, but for area expenses the papers would 
be retained or accumulated in the area office. 

7. Each plant would prepare each day a separate, delivery report for 
each area into which shipments are made. After audit in the area 
office, this delivery report becomes the control over delivery sta- 
tistics, which are kept in the area office. Production statistics 
would be accumulated only in the General Office, and all sales 
statistics would also be kept in New York. 

8. SaUuy personnel records for all persons in the centralized group 
would be kept in the Payroll Department in the General Office. 

9. Each area sales office would enter all sales made by it on its daily 
sales report. 



STRATFORD FOODS, INCORPORATED (I) 41 

10. Official cost cards for raw materials would be prepared in the 
General Office. 

11. Credits would be an area responsibility, with the area credit com- 
mittee composed of the area office manager, area credit manager, 
and the area sales manager for the activity concerned in each case. 
General supervision of credits would be a duty of the Office Ad- 
ministrator. 



B. Organization of the Controller's Department Under the General Plan 

At the time that certain accounting responsibilities for the Southeastern 
Division were transferred to the General Office, a decision was made 
that the staff members of the Controller's organization would be as- 
signed operating functions as an additional duty. Instructions would 
flow directly from the staff members to the area and plant office 
managers. However, the supervision of the outlying offices in respect 
to efficient operation, work scheduling, proper staffing, internal con- 
trol, audit follow-up, and salaries would be assigned to one man who 
had no other duties. 



Major Difficulties in General Plan 

The features of the General Plan which seem to present the major 
difficulties on the basis of discussion of the plan with the various stafiF 
members are as follows: 

1. Probably the point which gives most concern is the peak load 
created in the General Office, particularly in the Accounting and 
Tabulating Departments. The peak load problem in the General 
Office Accounting Department will be somewhat more acute than 
in a divisional office, since a higher percentage of the employees 
are involved in closing work. Although the planning in the Tabu- 
lating Department will have to be done most carefully, the peak 
load on tabulating in the Central Division is probably no more 
difficult to handle than will be the case in the General Office. 

2. The assigning of the duty of expense analysis on selling expenses 
and area administrative expenses to the area office, while plant 
expenditures are analyzed in the General Office, causes concern in 
several respects. First, the retaining of cash disbursements sup- 
porting papers in a location (the area office) other than where the 
cash disbursements journal is kept is not entirely sound in principle 
and will cause some difficulty in General Office audits. Second, the 
keeping of the expense ledgers and preparation of Monthly 
Budget Reports in a location (General Office) other than the office 
having expense analysis responsibility should be avoided if pos- 
sible. 

3. The desirability of clearing all branch sales office reports (as de- 
livery reports, branch vouchers, and deposit reports) through the 
area office, which is the control point for branch accounting, for 
review and audit before incorporating these reports into the general 
records will cause some additional delay over present practices. 



42 



NATURE OF THE CONTROLLER FUNCTION 



III. Cost Considerations Under General Plan 

In determining the cost of handling the accounting and statistical work 
under the General Plan as compared to present costs, it was assumed that 
no changes would be made except the following: (1) interdivisional trans- 
actions between the centralized group would be eliminated, (2) one clos- 
ing and statistical analysis of results would be made for the entire group, 
and (3) tabulating equipment at the General Office would be used for 
all journals, expense ledgers, and sales statistics. Additional savings will 
probably be more feasible under the General Plan, than under the present 
divisional basis, as discussed briefly later, but since these further economies 
will require much more study and planning, they could not be considered 
in this report. 

A. Major Cost Factors 

The major cost factors in adopting the General Plan are estimated to 
be as follows: 





Estimated 
Annual 
Savings 


Estimated 

Additional 

Annual Cost 


1. Recurring Items: 






a. Reduction in clerical personnel ... 

b. Additional rental of tabulating 
equipment 

c. Additional telephone, telegraph, 
and mailing expense 

d. Additional traveling expense 


$32,000 


$3,500 

2,400 
2,400 


Totals 

Less additional cost 


$32,000 
8,300 


$8,300 


Net Annual Savings 


$23,700 




2. Nonrecurring Additional Expenses: 






a. Moving expense 

b. Termination pay 


$26,000 
2,800 


'- 


Total Nonrecurring Expenses . 


$28,800 





B. Comments on Above Factors 

1. Reduction in Clerical Personnel 

There would be a decrease of 56 persons in divisional offices offset 
by an increase of 44 persons in the General Office, a net decrease 
of 12 employees. At $2,500 per employee plus 6% for payroll taxes 



STRATFORD FOODS, INCORPORATED (I) 43 

and retirement benefit expense, the saving for this reduction is 

about $32,000 annually. 

It is believed that the estimate of personnel requirements has been 

made conservatively and the decrease shown represents a minimum 

reduction. 

2. Additional Rental of Tabulating Equipment 

The probable changes in tabulating rentals resulting from adop- 
tion of the General Plan are shown separately and will be furnished 
on request. 

3. Additional Telephone, Telegraph, and Mailing Expense 

Because of the necessity for wiring or telephoning over longer 
distances in many cases (especially for the Southeastern and South- 
western areas), and because there will be considerable additional 
mailing of records (especially from area offices to the General Of- 
fice), it is estimated that expenses will be increased by about $200 
per month. 

4. Additional Traveling Expense 

The Office Administrator and his assistant will be required to make 
frequent trips to plant and area offices. This cost will be partly 
offset by decreased traveling by present divisional accounting ex- 
ecutives and by the General Office auditing staff. 

5. Moving Expense 

It is believed that about 26 persons would be transferred if the 
General Plan were adopted. It is estimated that about $1,000 per 
employee would be required for moving expenses. (Nine of the 
persons listed to be transferred are single and in one case the em- 
ployee's family is already located in New York. ) 

6. Termination Pay 

A total of 24 persons would be terminated under the tentative plans. 
Probably normal turnover would take care of about ten of this 
number, leaving 14 to whom termination pay would be paid. Most 
of these persons would undoubtedly be those that have been with 
the company for only a year or two, so it is not believed that 
termination pay would exceed $200 per employee. 



C. Additional Possibilities for Savings 

In my opinion there are potential savings which can be eventually 
realized under the General Plan which give promise of being con- 
siderably greater than $24,000 per year, as shown above. Since the ex- 



44 NATURE OF THE CONTROLLER FUNCTION 

' tent of these additional savings is impossible to estimate now with 

any degree of accuracy and since some of them might be realized even 

under the present divisional organization, but with more difficulty, no 

- dollar value can be placed on them. The major possible areas of addi- 

; ,_ tional savings which I have in mind are as follows: 

1. The General Plan should eventually result in reduction in cost of 
accounting supervision. This may not be evident at first because 

. ' of the necessity of placing men where they best fit into the new 

- organization, with only secondary consideration to salaries. Some 

reduction in costs should develop in the future, however, with the 
elimination of Division Controller positions and, in the larger 
divisions, the Chief Accountant positions, without creating cor- 
responding positions in the General Office. 

2. It may be possible to reduce office space requirements in some area 
locations as leases are renewed. 

3. The adoption of the General Plan will open new possibilities for 
' - Methods work, which has been or would be difficult to accom- 
plish under the divisional basis. 

? 4. It is believed that the clerical performance reports prepared will 

become more useful and will result in more aggressive action in 

|j j;|: reducing expense in below-standard offices. At present, when a 

division is told that its performance is not as good as other divi- 
sions, the meaning of the statement is lessened because the division 
to whom the comment is directed to is not acquainted with the 
offices to which comparison is being made. With a large group of 
mill and area offices under the one Office Administrator, compari- 
sons become more significant and are more likely to result in cor- 
rective measures. 

5. With peak loads (both monthly and annually) in the area offices 
considerably reduced, these offices can be operated more closely 
to minimum requirements, which might lead to economies. 

6. Possibly steps can be taken to purchase office supplies more eco- 
nomically. 

IV. Accounting and Statistical Service to Operators 

There is one general point in connection with service to operating execu- 
tives which is believed to be of considerable significance— namely, that 
adoption of the General Plan will provide uniform approach in gathering 
accounting and statistical data. It gives assurance to management that 
comparisons between plants, areas, or other units are valid, and gives 
added confidence to the Contioller's organization in interpreting the data 
for operators. Uniformity in this respect, which is either assured auto- 
matically under the General Plan or can be readily obtained, has been 
difficult to obtain with our accounting and statistics on a completelv 
decentraHzed basis. Under the centralized functional management, where 
decisions are made in New York for the entire group (rather than on a 
divisional basis), uniform approach and recording seems extremely desir- 
able, if not essential. 



STRATFORD FOODS, INCORPORATED (I) 



45 



EXHIBIT 4 

Proposed Controller's Organization 



VICE-PRESIDENT S CONTROLLER 



GENERAL 



FIELD OFFICE 
ADMINISTRATION 



METHODS COST BUDGETS OFFICE BUILDING 

ANALYSIS STATISTICS MANAGER MANAGER 



METHODS CREDITS 



STAFF WORK 

AND HOME 

OFFICE ACCOUNTING 

CONSOLIDATIONS 



PROPERTY 
RECORDS 



ANALYSIS STATISTICS BUDGETS DEVELOPMENT 



PLANT OFFICES 



DIVISION OFFICES 



ease 



BEECROFT MANUFACTURING COMPANY 

The Formulation of Accounting Statements 
and Their Use by Senior Executives 

This case raises the issue of what responsibility the controller has, to 
make data on operations available to directors on his own volition. 
It also poses the issue of whether secrecy of operating results is a 
good management policy. 

Operations 

The Beecroft Manufacturing Company was engaged in manufac- 
turing metal specialties, and its plants and general offices were lo- 
cated in Van Wert, Ohio. Its operations were in the two following 
principal lines: 

Refrigerator and Stove Hardware and Parts. These parts were 
sold directly to the refrigerator or stove manufacturer and consisted 
of small stampings and die castings which were either painted or 
electroplated, or both. All products in this line were manufactured 
in Plant A/except for a small amount of interplant transfers. 

Company Line. The principal product of the company line was a 
small, inexpensive electric broiler sold to jobbers, manufacturers' 
agents, and chain and hardware stores. This product was an as- 
sembly of stampings and purchased electrical parts, and was manu- 
factured in Plant B across the street from Plant A. The product was 
patented by Beecroft Manufacturing Company. 

Personnel 

The active direction of the corporation was vested in an executive 
committee consisting of the president, treasurer, and controller. The 
executive committee met at least once a week and oftener if occasion 
demanded. The principal operating officials of the corporation were 
the president, treasurer, controller, general sales manager, and pro- 
duction manager. The vice-president and secretary were not active 
in the daily plant operations. The president, although familiar with 

46 



BEECROFT MANUFACTURING COMPANY 47 

all the functions of the business, devoted his time principally to 
product manufacture and patent and development work. 

The general sales manager had direction of all sales activities of 
the company. He had a wide and respected reputation in the light 
manufacturing field and was conversant with the technical features 
of product design and manufacture. His training and experience, 
however, had furnished him with little background in cost or finan- 
cial accounting. Although the sale of refrigerator and stove hardware 
and parts was highly competitive, the general sales manager had 
been able to obtain a large share of this type of business. He felt that, 
although the prices obtained for these products were not under 
those of competitors, the reputation of the corporation, as to the 
quality of its product and service, presented a prospect for ever- 
increasing volume and profits. 

The controller was responsible for all records of the corporation 
and for the preparation of all accounting reports and statements. 
Each month the statements set forth in Exhibits 1-6 were prepared 
under his direction. The corporation operated under a modified 
standard cost system integrated with the general records. Detailed 
standard manufacturing costs were available on every product man- 
ufactured, together with budget schedules showing variances from 
standard costs by departments and items of cost. 

The production manager was in direct charge of all manufactur- 
ing operations in both plants and was responsible for direction of 
cost control in the plants. 

Organization 

The Beecroft Manufacturing Company was organized under the 
laws of the State of Ohio, and all of its common voting stock was 
held by a family group of six stockholders. The president, vice- 
president, and secretary were principal stockholders and members 
of the board of directors. The remaining members of the board of 
directors were another stockholder and an officer of the Commercial 
National Bank of Detroit. 

During the years following the Korean conflict, the corporation 
had made much needed improvements in its plant. This capital re- 
quirement, together with need for funds to finance inventories and 
accounts receivable, caused the corporation to seek loans from the 
Commercial National Bank of Detroit. As a result of this procedure, 



48 NATURE OF THE CONTROLLER FUNCTION 

the officer of the Commercial National Bank of Detroit in charge of 
the corporation account had been placed on the board of directors. 

General 

The vice-president of the corporation was a strong believer in the 
restriction of all financial information to the stockholder group. His 
attitude was that it was not only unnecessary but dangerous to dis- 
close any information as to profits, net worth, cash position, etc., to 
other than stockholders; and his attitude was expressed to the con- 
troller as follows: "We live in a small town, and, if our employees 
learn our profits or our net worth, the information will spread all 
over town and be distorted. Never let our operating officials or our 
workers learn what we are earning. It will cause trouble." 

This attitude caused the controller considerable embarrassment 
when talking to operating officials. Because of the size of the cor- 
poration, all of its operating officials were on very close terms and 
discussed many of the problems of the business freely. It was not 
uncommon for the controller to be asked by the production manager, 
or the general sales manager, "How did we make out last month? 
Did we show pretty good profits?" 

The statements showing the relative profitability of the two plants 
had been made available to members of the executive committee 
and to the vice-president but not to other directors or operating 
officials. The other directors and the bank were furnished with copies 
of Exhibits 1 and 2. 

^ What action should the controller take under these circumstances? 



BEECROFT MANUFACTURING COMPANY 



49 



EXHIBIT I 

Balance Sheets-March 31, 1957, and February 28, 1957 





March 31, 1957 


February 


28, 1957 


Assets 










Current: 










Cash on Hand and in Bank 




$ 74,763 




$ 69,327 


Marketable Securities 




17,163 




17,163 


Accounts Receivable Trade-Net 




514,123 




468,977 


Inventories: 










Raw Material 


$202,604 




$197,604 




Work in Process 


152,167 




125,334 




Finished Goods 


41,172 




37,626 




Stores 


115,621 


511,564 


114,137 


474,701 


Prepaid Expenses 




5,163 




5,327 


Total Current 




$1,122,776 




$1,035,495 


Fixed: 










Land 


$ 32,174 




$ 32,174 




Buildings 


246,927 




246,927 




Machinery and Equipment 


460,573 




458,429 




Delivery Equipment 


8,273 

$747,947 




8,273 
$745,803 




Less Reserves for Depreciation 


196,448 


551,449 


193,108 


552,695 


Patents Less Amortization 




18,726 




18,986 


Total Assets 




$1,693,001 




$1,607,176 


Liabilities and Net Worth 










Current: 










Notes Payable-Commercial Na- 










tional Bank of Detroit 




$ 200,000 




$ 150,000 


Accounts Payable 




163,764 




159,899 


Accrued Taxes 




82,173 




84,864 


Accrued Wages 




16,122 




9,766 


Accrued Commissions 




3,423 




2,603 


Total Current 




$ 465,482 




$ 407,132 


Fixed: 










Notes Payable-Commercial Na- 










tional Bank of Detroit, Due 










November 1, 1960 




150,000 




150,000 


Net Worth: 










Capital Stock, 80,000 shares-Com- 










mon Stock $10 Par Value, Issued 










and Outstanding 


$800,000 




$800,000 




Earned Surplus 


277,519 


$1,077,519 
$1,693,001 


250,044 


$1,050,044 
$1,607,176 



EXHIBIT 2 

Profit and Loss Account— March, 1957 



. , -. ^ -■ -- ' 


March, 1957 


February, 1957 


Increase 
Decrease * 


Gross Sales 

Less Returns and Allowances 

Net Sales 

Cost of Sales: s , 
Material 
Labor— Direct 
Factory Overhead 

Gross Profit 

Commercial and Administrative Ex- 
pense 

Operating Profit 

Other Income— Net 

Net Profit-Before Federal Income 
Taxes 

Provision for Federal Income Taxes 

Net Profit to Surplus 

% to Net Sales 


$503,387 

4,364 

$499,023 

■ 220,382 

87,941 

121,291 

$429,614 

$ 69,409 

27,198 

$ 42,211 

1,764 

$ 43,957 
16,500 

$ 27,475 
5.5% 


$463,867 

4,471 

$459,396 

203,069 
79,930 

111,862 
$394,861 
$ 64,535 

25,084 

$ 39,451 

1,673 

$ 41,124 
15,600 

$ 25,524 
5.6% 


$39,520 

107* 
$39,627 

17,313 
8,011 
9,429 

$34,753 
$ 4,874 

2,114 

$ 2,760 

91 

$ 2,851 

900 

$ 1,951 



EXHIBIT 3 

Profit and Loss Account, by Plants 
March, 1957, and February, 1957 



Plant A 
Mar. 1957 Feb. 1957 



Plant B 
Mar. 1957 Feb. 1957 



Total 
Mar. 1957 Feb. 1957 



Net Sales 

Cost of Sales: 
Material 
Labor 

Factory Over- 
head 



Gross Profit 
Commercial and 
Administra- 
tive Expense 
Operating 
Profit 

% to Net Sales 
* Red. 



$325,462 $297,963 

$156,222 $144,008 
63,643 57,166 



98,127 



89,741 



$317,992 $290,915 
$ 7,470 $ 7,048 

17,775 16,121 



$ 10,305* $ 9,073^ 

3.2%* 3%* 



$173,561 $161,433 

$ 64,160 $ 59,061 
24,298 22,764 



23,164 



22 121 



$111,622 $103,946 
$ 61,939 $ 57,487 



9,423 



8,963 



52,516 $ 48,524 
30.3% 30.1% 



$499,023 $459,396 

$220,382 $203,069 

87,941 79,930 

121,291 111,862 



$429,614 $394,861 
$ 69,409 $ 64,535 

27,198 25,084 



42,211 $ 39,451 
5.5% 5.6% 



50 



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51 



EXHIBIT 5 



Commercial and Administrative Expense— March, 1957 



March 1957 

Officers' Salaries $ 4,800 

Office Salaries 12,542 

Commissions to Agents 3,423 

Office Supplies 1,153 

Telephone and Telegraph 563 

Group Insurance 865 

Postage 144 

Traveling 723 

Advertising 2,109 

Legal and Professional 240 

Dues and Subscriptions . . 60 

Social Security Tax 142 

Depreciation 212 

Miscellaneous 223 

$27,198 

Allocated: * 

Plant A $17,775 

Plant B 9,423 



$27,198 



February 1957 

$ 4,800 

12,467 

2,603 

844 

571 

847 

132 

674 

1,387 

200 

40 

130 

212 

177 



$25,084 

$16,121 

8,963 

$25,084 



* Allocation is made to plants on the basis of specific information where available. The remaining amount 
allocated on the basis of percentage of sales. 



EXHIBIT 6 

Fixed Assets and Reserves for Depreciation— March, 1957 



, 


Fixed Assets 




Balance 
Mar. 1,1957 


Additions 


Balance 
Mar. 31, 1957 


Land 

Buildings 


$ 32,174 

246,927 

458,429 

8,273 

$745,803 




$ 32,174 
246,927 


Machinery and Equipment 

Delivery Equipment 


460,573 

8,273 






$747,947 





Reserves for Depreciation 




Balance 
Mar. 1,1957 


Additions 


Balance 
Mar. 31, 1957 


Land 

Buildings 


$ 55,710 

131,280 

6,118 

$193,108 


$ 614 

2,602 

124 

$3,340 


$ 56,324 


Machinery and Equipment 

Delivery Equipment 


133,882 

6,242 

$196,448 



52 



section TW^O. 



Internal Control 
and Internal Audit 



One area of management that affects all phases of a company's 
operation and which is generally the direct responsibility of the controller 
is internal control. Internal audit, too, whether considered as a separate 
function or as a part of internal control, affects all areas of operations. 
This is particularly true since the internal audit function has been 
expanded in many companies to become, in part, the "eyes of manage- 
ment." 

The following cases examine the problem of planning and using the 
concept of internal control in safeguarding assets and reviewing oper- 
ations. The problem of weighing the benefits derived against the cost 
involved comes up for constant re-examination. Other cases examine the 
role of the internal auditor in a company's operation. The internal auditor 
does not in all the cases below report to the controller; but his work falls 
within the controller function as defined in this book. 

A. Internal control 

6. Oatsy-Toasty Company 

7. Hartshorn Furniture Company 

8. Hillyard Iron Works, Incorporated 

9. Drayer-Hanson, Incorporated 

10. Algonquin Rubber Company 

B. Internal audit 

11. Stratford Foods, Incorporated (II) 

12. Richland Corporation 

13. Northern Alliance Company 

14. The Dolphin Manufacturing Company 

15. The Westco Oil Company 

53 



case 



6 



OATSY-TOASTY COMPANY 

Problem of Internal Control 

This case presents a problem of cash control for a company starting 
a large premium program involving cash and box tops for premiums. 

The Oatsy-Toasty Company was a manufacturer of a well-known 
breakfast cereal— Oatsy-Toasty. Approximately 200 people were em- 
ployed in its general office in Kansas City, Missouri. 

Receipts from the sale of its product were deposited by branch 
sales offices in bank accounts in the principal cities of the country 
and duplicate deposit slips forwarded to the cashier's department in 
the general office. 

In an effort to stimulate sales, the sales department was contem- 
plating a premium offer of a toy compass in exchange for one box top 
plus 15 cents in cash ( stamps not accepted ) . It was estimated that, 
after the premium advertising campaign had been instituted, ap- 
proximately 800,000 requests for premiums would be received. Three 
months were scheduled for the premium offer and replies were ex- 
pected roughly in this order: 

1st month 200,000 

2nd month . . 350,000 

. 3rd month 250,000 

.. 800,000 

An outline of the major checks made by the internal auditing de- 
partment is shown in Exhibit 1. 

As a member of the internal auditor's staff attached to the con- 
troller's office, you are requested to prepare a summarized program 
on the two following points : 

What preliminary advice, if any, should be furnished the sales de- 
partment prior to the offer? 

What specific procedures do you recommend to control the receipt 
of cash for premiums? 

54 



OATSY-TOASTY COMPANY 55 

EXHIBIT 1 

Auditing Department— Outline of Major Checks 

FINANCIAL STATEMENT 
I. CASH 

A. Cash on Hand 

a. Count petty cash fund immediately upon arrival at offices, 
and check total to general ledger. 

B. Cash in Banks 

1. Divisional and district offices 

a. Obtain bank reconciliations for preceding month-end, verify 
them in detail, and investigate internal control. 

b. Reconcile bank balances to general ledger. 

c. Examine bank reconciliations for three other months. 

d. Examine checks returned with bank statements of latest 
month for dates, amounts, payees, signatures, endorsements, 
and cancellations. 

e. Verify checks outstanding at previous audit by inspection of 
returned checks. 

2. General office 

a. Prepare a daily report of depository cash balances. 

b. Verify daily transfers of funds from divisions. 

c. Verify all transfers of funds between bank accounts. 

d. Prepare monthly reconciliations of all bank accounts. 

e. Trace cancelled checks to cash disbursements journals. 

f. Examine endorsements on cancelled checks returned with 
bank statements for one month in each fiscal year. 

g. Investigate voided checks and reasons therefor in connection 
with each monthly reconciliation. 

II. RECEIVABLES 

A. Current, Doubtful, Memo Bad Debt, and Miscellaneous Accounts 

a. Circulate verification statements to customers and/or col- 
lection agencies. 

b. Inspect all notes and collateral, if any. 

c. Ascertain that no accounts have been removed from bad debt 
ledger without authority. 

d. Determine that transfers to allowance account are in ac- 
cordance with requirements of accounting instructions. 

B. Drafts Receivable 

1. Drafts deposited with central bank for collection 
a. Verify by correspondence with central bank. 

2. Drafts handled under Transcontinental Collection Svstem 

a. Verify with collection banks all past-due drafts, all sight and 
arrival drafts over ten days old, all straggling balances, and 
a sufficient number of additional drafts to constitute a total 



56 INTERNAL CONTROL AND INTERNAL AUDIT 

verification of at least fifty per cent of the total amount out- 
standing. 

C. Foreign Accounts 

a. Verify balances by examining subsequent collections, or cir- 
culate verification statements to customers or collection agen- 
cies if such action is practical and a satisfactory confirmation 
of the accounts cannot otherwise be secured. 

III. INVENTORIES 

A. Finished Products 

1. Major warehouse stocks 

a. Count all stocks. 

b. Examine physical condition of stock and storage facilities. 

c. Determine frequency of counts by local personnel, and re- 
view the differences disclosed and the disposition thereof. 

d. Review old stock reports prepared locally and check method 
of preparation. 

e. Review turnover figures on warehouse stocks, if available. 

2. Smaller branch stocks (less than 500 cwts. or equivalent) 

a. Check salesmen's recent counts or verify by correspondence 
with warehousemen. 

b. Review frequency of counts by company representatives. 

c. Review differences disclosed by previous counts by company 
representatives and determine disposition of such differences. 

d. Review old stock reports prepared locally and check method 
of preparation. 

e. Review turnover figures on warehouse stocks, if available. 

3. Merchandisers' truck stocks 

a. Review frequency and results of stock audits made by com- 
pany supervisors. 

4. Foreign stocks 

a. Review frequency and results of stock audits made by com- 
pany representatives or public auditors. 

B. Empty Packages 

a. Count all secondhand cartons and sacks and selected repre- 
sentative brands of larger sizes of new cartons and sacks. 

b. Review frequency and results of local counts of sacks. 

c. Review local reports of slow-moving and inactive sacks. 

d. Test-count approximately fifty per cent of the containers, 
cartons, and shells at cereal plants. 

e. Inspect physical condition of inventory and storage facilities. 

C. Premium Stocks and Coupons 

a. Test-count stocks of premiums and coupons. 

b. Determine frequency of counts by local personnel, and re- 
view the differences disclosed and the disposition thereof. 

c. Review procedures in effect for controlling cash-value cou- 
pons, from both physical and accounting points of view. 



OATSY-TOASTY COMPANY 57 

d. Conduct investigations of questionable silverware orders 
through division controllers as such orders are referred to the 
Auditing Department by the Coupon Service Department, 
and recommend to the latter department that orders be filled 
or declined on basis of these investigations. 

D. Valuation of Inventories 

a. Determine accuracy of cost cards where applicable. 

b. Test-check accuracy of pricing and extending. 

c. Review procedures, basis of valuation, and unusual factors 
or adjustments. Make tests to determine that local checks are 
operative. 

IV. OTHER ASSETS 

A. Prepaid Expense 

a. Check quantities and valuations set-up in latest closing. 

b. Investigate control over tangible assets represented. 

B. Prepaid Insurance 

a. Review schedules for unusual factors. 

b. Check accuracy of monthly write-offs and of prepaid balances 
on company car ledger. 

C. Employees' Expense Advances 

a. Confirm balances by verification statements if such statements 
have not been circularized within the last six months. 

D. Company Cars 

a. Review schedules for unusual factors. 

b. Check accuracy of capitalization (from vouchers) of all 
automobiles acquired during the audit period. 

c. Check accuracy of depreciation charges and of depreciated 
balances on company car ledger. 

d. Review adequacy of control over (and reimbursement for) 
personal use of company cars. 

E. Due from Employees 

a. Review local trial balance for regularity of payments and 
unusual factors. 

b. Examine notes covering emergency loans to employees, and 
ascertain that each loan is properly approved. 

F. Termination Accounts Receivable 

a. Verify by correspondence with debtors or collecting agen- 
cies, or both. 

b. Review accounts with credit manager and/or sales manager 
for probability of collection. 

G. Advances to Venders 

a. Verify balances by correspondence or by subsequent collec- 
tions. 



58 INTERNAL CONTROL AND INTERNAL AUDIT 

^ H. Stocks, Bonds, and Miscellaneous Investments 

a. Examine any securities carried on records of outside offices, 
and investigate bases of valuation. 

I. Fixed Assets 

a. Test-check the physical existence of machinery and equip- 
ment to and from the equipment number records secured 
from Kansas City. 

b. Review procedures for assembling charges against open 
projects and work orders. 

c. Test-check accuracy of charges to open projects or work 
orders from supporting papers. 

V. LIABILITIES 

A. Accounts Payable 

a. Review schedules of unpaid bills for reasonableness and for 
unusual factors. 

b. Make suitable verification of larger miscellaneous accounts 
payable. 

c. In connection with audit of vouchers, determine any omissions 
from previous monthly schedule of unpaid bills. 

B. Thrift Accounts 

a. Investigate procedures for accruing and crediting interest, 
and test-check the accuracy of such computations. 

C. Accrued Taxes 

a. Investigate procedures and review the tax accrual for rea- 
sonableness. 

D. Provision Accounts and Reserves 

a. Make no audit of balances or transactions in the provision 
accounts. 

E. Capital and Surplus 

a. Make no audit of balances in capital and surplus accounts. 



INCOME AND DISBURSEMENTS 
VI. INCOME 

A. Invoicing 

a. Check invoices applying on contract for one month for all 
factors. 

b. Trace invoices for one month to the invoice journal. 

c. Check footings and cross-footings of invoice journal for two 
months, and trace totals to general ledger. 

d. Review corrections issued during several months of the audit 
period. 



OATSY-TOASTY COMPANY 59 

B. Cash Receipts 

1. Divisional and district offices 

a. Check all cash receipts for two months from deposit reports 
and other supporting papers to cash receipts book and bank 
statements. 

b. Check individual collection reports for two periods of two 
weeks each to deposit reports. 

c. Check footings and cross-footings of cash receipts journal for 
two months, and trace totals to general ledger. 

d. Watch for unrecorded receipts. 

2. General Office, Kansas City 

a. Check daily deposits to General Office, in concentration cen- 
ter banks under the Transcontinental Collection System. 

b. Check daily deposits to the accounts of Oatsy-Toasty Inc. 
(consisting of those by the executive offices, by the Mechani- 
cal Division, by the Minneapolis grain department, by the Re- 
search department, by the Coupon Service department, by 
the Twin City and Great Falls offices of Central Division, by 
the New York offices of the Eastern and Special Commodities 
Divisions, by the Minneapolis offices of the Chemical and 
Purity Oats Divisions, and by the entire Farm Service Divi- 
sion ) . 

c. Make no audit of the detail of General Mills collections re- 
ceived and deposited at Minneapolis. 



VIL PURCHASES 

A Grain, Including Coarse Grains 

a. Check in detail ten to fifteen per cent of carload grain settle- 
ments issued to and received from outside dealers. 

b. Check detail of ten to fifteen per cent of cash car- purchases 
made during audit period. 

c. Check all cargo purchases. 

d. Check all delivery wheat taken during period. 

e. Check ten to fifteen per cent of truckload grain settlements. 

f. Check ten to fifteen per cent of country elevator warehouse 
receipts issued. 

g. Check future transactions for two half-months. 

h. Check purchase and sales statements from brokers for two 
half-months. 

B. Merchandise and Ingredients 

a. Check transactions for one month against purchase records 
for correctness of application, pricing, and bases. 

b. Test-check entries in purchased merchandise journal from 
original copies of material received reports. 

c. Test-check freight payments on merchandise purchased f.o.b. 
destination. 

d. Verify by correspondence all purchases with outside vendors 
that have remained open for sixty days or more. 



60 INTERNAL CONTROL AND INTERNAL AUDIT 

C. Empty Packages 

a. Check in detail all purchases for one full month. 

b. Check purchases encountered in two scattered half-months 
when auditing the cash disbursements. 

c. Test-check individual receiving reports, using the copy at- 
tached to vouchers, to the inventory records. 

d. Review local verification of sacks in hands of vendors. 

e. Review local verification of contract balances with bag com- 
panies if contracts are placed locally. 

D. General Office Purchasing Department 

a. Verify open purchase contracts of the department. 

b. Examine the national contracts and the empty package pur- 
chases placed for the operating divisions. 

c. Test-audit purchases made through the department. 

d. Review procedures and responsibilities for obtaining bids on 
supplies and receiving special discounts. 

- e. Test-check preparation of principal operating reports used 

by the management. 

f . Review control exercised by purchasing department over pur- 
chasing activities of the divisions. 

g. Review position reports in relation to the policies of the Pur- 
chasing Committee. 

VIII. OTHER DISBURSEMENTS 

A. Expenses and Miscellaneous Disbursements 

a. Audit in detail all vouchers for one full month and every 
third voucher in two scattered months. 

b. Check the vouchers for the full month audited to the cash 
, disbursements journal. 

c. Verify footings and cross-footings of the cash disbursements 
journal for two months, and trace totals to general ledger. 

d. Check some vouchers for one month against truck slips or 
other record of receipts from vendor in receiving clerk's 
office. 

e. Examine ten to fifteen per cent of the expense drafts issued 
at country elevators for supporting papers, approvals, and 
distributions. 

f. Review expense schedules, and investigate unusual items, 
particularly the less controllable ones such as postage, express, 
and unclassified expense. 

g. Review all procedures in detail. 

B. Factory Payroll 

a. Distribute all wage pay checks included in first payroll after 
auditors' arrival, securing employees' signature of receipt. 

b. Compare signatures secured with those in Personnel Depart- 
ment files for authenticity. 

c. Compare names obtained with names on preceding payroll, 
and investigate all additions or deductions. 



OATSY-TOASTY COMPANY 61 

d. Check one payroll for rates, time, extensions, authorizations, 
and procedures. 

C. Salary Payroll 

a. Investigate procedures and test-check accuracy of overtime 
payments to salaried employees and of salesmen's incentive 
payments. 

D. Dividends 

a. Compare the dividend check data in Kansas City with that 
in the certified listings secured from the Transfer Agent 
yearly. 

OPERATIONS 

IX. INSURANCE REPORTS 

a. Review basis on which insurable values of inventories are 
reported to Kansas City. 

b. Review reports for one month to determine that procedures 
are adequate and that principal factors are given considera- 
tion. 

c. Once each year, summarize and analyze losses reported to 
bonding companies. 

d. Make no audit of records and activities of Kansas City In- 
surance Department. 

X. SALES RECORDS 

SL. Investigate the sales records procedures. 

b. Determine from local reports the extent of past-due contracts 

on unfilled orders report of previous month, and review major 

past-due bookings with sales executives. 

XL CREDITS 

A. Analytical Schedules 

SL. Prepare comparative aged trial balance of current accounts 
receivable as of present and previous audit. 

b. Compute net change in total old accounts during period. 

c. Determine rate of bad debt loss on deliveries involving credit. 

d. Prepare analysis of controls for Doubtful Customers' Accounts 
Receivable and Allowance for Bad Debts from local sum- 
maries. 

B. Review of Accounts 

a. Review with credit manager all customers' accounts over 
thirty days old, all past-due draft accounts, and all doubtful 
and memo bad debt accounts. 

b. Test-review condition of credit files by examining those for 
selected accounts (particularly including old and large ac- 
counts), and examine credit limits and terms for the accounts 
involved. 



62 INTERNAL CONTROL AND INTERNAL AUDIT 

c. Determine whether credit committee operations conform with 
executive requirements. 

d. Review files on all accounts in hopeless section of bad debt 
ledger to confirm uncollectible status of these accounts. 

e. Review accounts charged off during period to determine that 
company requirements are being followed. 

C. General 

a. Review procedures to determine that in general company 
policy and executive requirements are being followed. 

XII. TRAFFIC 

A. Transit Operations 

a. Check in detail the accuracy of the transit inventory as of 
the most recent closing. 

b. Review procedures, monthly reports, and reconciliations re- 
I _ lating to control over transit billing and relationship of stocks 

and billing. 

c. Make no review of billing applications. 

B. Freight Payments 

a. Check freight payments on inbound and outbound shipments 
for one or two weekly periods. 

b. Check payments for demurrage incurred during audit period 
and investigate control over this expense. 

C. Transportation Claims 

a. Review records and procedures. ' 

b. Review uncollected claims. 

D. General 

a. Review procedures in compiling freight variations and check 
variations for one month. 

XIII. MISCELLANEOUS 

A. General Procedures 

a. Investigate adequacy of internal control. 

b. Review records and procedures involved in various opera- 
tions. 

c. Determine that procedures conform to authorized manuals 
and accounting instructions. 

B. Foreign Exchange 

a. Verify foreign exchange position of New York Export Office. 

b. Review foreign exchange operations to determine that no 
speculative position has existed. 

C. Organization Charts 

a. Prepare organization charts of each office. 

b. Determine reasons for increase or decrease in personnel. 

c. Secure executive approval on charts prepared. 



OATSY-TOASTY COMPANY 63 

D. Statistical Records 

a. Make no review or verification of statistical records, other 
than to ascertain that they are being maintained in a current 
condition. 

E. Special Audits 

a. Audit Coupon Service Department, Advertising Department, 
and Research Laboratory at approximately eighteen month 
intervals. 

F. Other Operations 

a. Review the procedures and computations on interdepart- 
mental contracts. 

b. Review journal entries and credit names for two months of 
audit period. 

c. Inspect general records, and check closing work sheets for 
latest month. 

d. Test-check various reports prepared for operating usage. 

e. Investigate and report to General Auditor on propriety of 
exemptions under Wage and Hour Law (lists of such exemp- 
tions furnished by the Personnel Department) . 

XIV. AUDIT REPORTS AND FOLLOW-UP 

A. Audit Reports 

1. Summarized reports 

a. Issue copies to General Office executives and division chief 
executive. 

b. Issue report within fourteen days of the completion of the 
audit. 

2. Detailed reports 

a. Circulate copies to interested department heads of General 
Office and divisional controller. 

b. Issue report within six weeks of the completion of the audit. 

B. Audit Follow-up 

a. Maintain follow-up files on each office audited. 

b. Institute follow-up for complete settlement of weaknesses and 
suggestions presented in report. 



ease 



HARTSHORN FURNITURE COMPANY 

Problem of Internal Control 

In this case a specific problem of fraud is presented showing a 
defect in the internal control procedures of a national chain of 
furniture stores. 

The following case of fraud is reported to you as chief auditor of 
a large national chain of furniture stores. 

In your Pittsburgh store two elderly ladies purchased $1,200 worth 
of furniture on an installment account. Terms were monthly pay- 
ments of $100 per month for twelve months. The furniture was to be 
used in a genteel rooming house and the ladies had adequate credit 
references. Each month for six months the ladies appeared at the 
store with a check for $200, asking to receive $100 in cash as change. 
They pointed out they only came to the shopping area once a month 
and they could by this procedure avoid a trip to the bank. The 
seventh month they failed to appear, and after notice of a past due 
payment, they wrote to the store saying they had paid in full, and 
they had cancelled checks to prove it. A local attorney of the com- 
pany advised the company not to attempt suit. 

Each person having an installment account received a book sim- 
ilar to a bank book. As payments were made, the store cashier entered 
the date and amount of payment and returned the book to the pur- 
chaser. The cashier, in addition, prepared a remittance slip for 
company internal use, showing name, date, amount, and account to 
be credited. 



What change in procedure would you institute to avoid a repetition 
of this fraud? 



64 



ease 



8 



HILLYARD IRON WORKS, INCORPORATED 

Raw Material Control 

This case raises the issue of effective control over ravy/ material in- 
ventories. The purpose and value of typical perpetual inventory 
records are examined. 

In late 1957 the management of the Hillyard Iron Works, a large 
foundry located in the vicinity of Detroit, was apprehensive about 
the system by which the company handled its raw material from the 
time it was purchased until used in the production process. Particu- 
larly, the management was concerned about the physical control over 
its scrap and pig iron inventories and about the proper mix of these 
raw materials in the production of castings. 

The Hillyard Iron Works, Inc., was a subsidiary of Hillyard Ma- 
chines Corporation, a manufacturer of machine tools. The iron works 
produced castings for various machine tools used in the automotive 
manufacturing industry. The company employed about 300 men in 
its shop. 

The Production Process 

The operations in the foundry could be broken down into three 
phases: (a) mold making, (b) pouring off, and (c) removing and 
cleaning the casting. 

The mold is formed by impressing a pattern (a wood, aluminum, 
or cast-iron replica of the part to be cast) in a box of mold- 
ing sand. Where openings or holes are required in the casting, cores 
of baked sand are placed in the proper position in the sand mold. 
The mold is then ready for pouring. 

Pouring off is the process by which the molten iron is transferred 
from the furnace, by means of large, specially constructed buckets, 
to the mold. After the molds have been allowed to cool, the sand is 
removed from the casting and the casting is then cleaned and 
finished. 

The raw material which feeds this process is the molten iron, or 

65 



66 INTERNAL CONTROL AND INTERNAL AUDIT 

melt. The melt is prepared by "charging" the furnace with coke, pig 
iron, scrap iron, limestone, spiegeleisen (a manganese compound), 
and other chemical ingredients. The charge is heated by firing the 
coke under forced draft until the iron is brought to the critical tem- 
perature. Great care is required in heating the charge. If the iron is 
poured when too cool, it will not run properly. If, on the other hand, 
the iron is too hot, it takes on certain undesirable chemical properties. 
There were two means by which the company tried to control the 
heating of the charge. Men who had had long experience in the 
heating of charges tried to determine by inspection, through a special 
quartz eye hole provided in the furnace, when the charge had 
reached the proper temperature for pouring. Secondly, physicists, 
with spectrometers— instruments used to aid in the computation 
of the heat of the furnace by measuring light intensity— tried to de- 
termine when a charge was ready to be tapped. 

The furnaces are about 40 feet in height. The tap hole from which 
the molten iron is poured is located at the base in front of the furnace. 
About 15 feet up, at the back of the furnace, is a large aperture 
through which the furnace is charged. The charge is fed into the 
furnace at this opening and is slowly melted until it reaches the 
proper temperature to be poured into the molds. Hillyard normally 
operates only one furnace at a time. Since the intense heat makes the 
frequent replacement of fire bricks necessary, and because a furnace 
requires an "overhaul" after each day's operation, three furnaces 
were considered necessary in order to insure the continuous opera- 
tion of one. 

Raw Materials 

All raw materials, with the exception of chemicals, were purchased 
by Hillyard in carload lots. Coke and limestone, for example, were 
brought in by the carload and deposited in bins, each of which held 
one carload. Thus by tallying the number of bins a rough phvsical 
inventory count was provided. Valuing each bin was not difficult since 
the price of each carload was known. When all bins had been 
counted, priced, extended, and totalled, a raw^ material inventory 
figure for coke or limestone was available for balance sheet presen- 
tation. Perpetual inventory records were maintained for these items, 
and official physical inventories were taken twice a year. At various 



HILLYARD IRON WORKS, INCORPORATED 67 

times during the year, the shop superintendent made additional un- 
official checks by noting the number of full bins and comparing them 
with perpetual inventory records. 

Purchases of coke and limestone were made on the basis of inven- 
tory records. Recorders were placed on a maximum-minimum basis. 
Materials were purchased by the pound even though there were only 
slight variations from carload to carload. They were ordered into pro- 
duction by the bin. The Hillyard management believed it exercised 
adequate control over these raw materials. 

Even more exact information was kept on the spiegeleisen and 
other chemical compounds. Since relatively small quantities of these 
items were used, the amounts were carefully measured out on a small 
scale used solely for the purpose. Perpetual inventory records were 
maintained and semiannual physical inventories taken. Purchase 
procedure was the same as for coke, except that closer control over 
the quantity on hand was considered essential in view of the high 
cost of these items. 

The company's management felt somewhat less comfortable, how- 
ever, about the degree of control it exercised over the purchase, stor- 
age, and consumption of its scrap and pig iron and the method by 
which the inventories of those items were valued for balance sheet 
presentation. 

Scrap iron was stored in a large pile in the yard behind the 
foundry. Pig iron was kept in bins behind the base of the furnace 
inside the foundry. Pig iron was delivered directly from freight cars 
to the bins by way of a railroad siding which ran into the shed. Scrap 
and pig iron were purchased by the ton, and Hillyard purchased 
both items in carload quantities. Quantities billed by suppliers were 
checked by Hillyard by weighing the loaded cars when received and 
deducting the known weights of the freight cars empty. Discrepan- 
cies between quantities billed and received were extremely rare. 
The absence of such discrepancies was probably due in part to the 
fact that each carload was weighed four times during shipment; 
once by the shipper; twice by the railroad ( at shipping point and at 
destination ) ; and once by Hillyard. 

Hillyard used about 250 tons of pig iron per month and about 
350 tons of scrap. A carload contained approximately 50 tons of pig 
iron or about 35 tons of scrap. The company tried to maintain a two- 



68 INTERNAL CONTROL AND INTERNAL AUDIT 

to three-month supply of both pig and scrap iron on hand at all 
times. The prices of these two items in July, 1957, were, for scrap iron, 
about $54 per ton; and for pig iron, about $66 per ton. 

Hillyard normally charged its furnaces about 10 times a day. The 
amount of pig iron in a charge ranged from 1,600 to 2,000 pounds. 

The Hillyard management was particularly concerned over re- 
peated discrepancies which were showing up between the amount 
of iron inventories reflected by the perpetual inventory records and 
the amount disclosed by physical measures or counts of inventories. 
For some time quarterly physical inventory checks had indicated 
somewhat less than a month's supply on hand when stores records 
indicated inventories sufficient for two months' operations. Although 
it was generally believed that some discrepancy between inventory 
records and physical counts could be expected, because of the dif- 
ficulty of "counting" iron inventories, it was somewhat disconcerting 
that the count should always be on the low side. 

The method of controlling pig and scrap iron at Hillyard was 
similar to that of controlling coke. Perpetual inventory was kept, in 
pounds, and purchases were recorded on the inventory card. Buying 
was done on a maximum-minimum basis. Each production card 
ordering iron out of inventory was recorded, the amounts ordered out 
being determined by weight. Each cupola of pig or scrap iron was 
weighed as it was pushed up to the blast furnace. This weight was 
recorded as the amount entering each charge. 

After studying the company's inventory system, the management 
came to the conclusion that the cause of the loss of iron was the 
inaccuracy of the scale. Company officials had the scale tested and 
calibrated frequently, but the loss of iron continued. Finally engi- 
neers inspected the system, and their conclusions, although not cer- 
tain, were to the effect that the first load each morning threw the 
scale off, and each load thereafter heightened the defect. After a 
night of non-use, the first weighing in the morning was accurate. 
The inaccuracy in the scale was believed to come from the con- 
tinuous shock of having heavy loads dropped on it. It was not be- 
lieved that a new scale would overcome this problem, nor had the 
company been able to change its handling procedure to lessen the 
shock. 

The extent of the inventory losses that might possibly arise through 
inaccurate measures of amounts consumed is indicated bv the dailv 



HILLYARD IRON WORKS, INCORPORATED 69 

usage of iron. The furnace was usually charged 10 times a day, each 
charge, in the case of pig iron, consisting of from 1,600 to 2,000 
pounds. Thus, an error in the measurement of the charges of even 
5% or 10% could account for a loss of about 25 tons in a month. 
Actually, according to the company's estimates, as much as 75 tons 
of pig iron had disappeared in a month indicating error somewhat 
in excess of 10%. Similarly, an error of 10% in measuring the amount 
of scrap iron used could result in the loss of 35 tons ( one carload ) 
in about a month and a half. The company had never lost more than 
one carload in a month. 

As a step toward determining the cause of these so-called inventory 
losses, and toward the establishment of more realistic inventory 
figures than the management felt had appeared in past financial 
statements, the company, in 1957, hired an engineering firm to con- 
duct a monthly physical inventory count. Each month, inventory 
records were adjusted to agree with the engineers' findings. 

EXHIBIT I 

Hlllyard Machines Corporation 
Balance Siieet— December 31, 1956 

Assets 

Cash and Securities $ 2,000,000 

Receivables, net 3,400,000 

Inventory 6,000,000 

Income Tax Refund 150,000 

Total Current Assets $11,550,000 

Fixed Assets, net 10,000,000 

Prepayments 4,500,000 

Total Assets $25,050,000 

Liabilities 

Accounts and Notes Payable $ 2,000,000 

Accrued Taxes 600,000 

Federal Income Tax Reserves 2,000,000 

Total Current Liabilities $ 4,600,000 

Capital Stock 10,000,000 

Capital Surplus 6,000,000 

Earned Surplus 4,450,000 

Total Liabilities $25,050,000 

The Hillyard management considered the use of the engineering 
staff only an interim arrangement pending the development of a 
sounder basis for the control of its pig and scrap iron through the 
complete cycle of purchasing, storing, and using. 



70 INTERNAL CONTROL AND INTERNAL AUDIT 

The balance sheet of the parent company, Hillyard Machines 
Corporation, as of December 31, 1956, is shown in Exhibit 1. No 
separate figures were available for the Iron Works. 

How would you approach this company's inventory control problem? 
Do you think this problem can be best solved by correcting the scale? 



ease 



9 



DRAYER-HANSON, INCORPORATED 



Work in Process Inventory Control 
In the Matter of Drayer-Honson, Incorporated ^ 

This case examines the action of the Securities and Exchange Com- 
mission in a case involving an accounting error. It also considers the 
problem of appraising internal control procedures for in-process 
inventories. 

Action by the Securities and Exchange Commission against ac- 
countants whose work is deemed deficient may result in direct disci- 
phne by the Commission in the form of suspension or disquaHfication 
from practice before it, or in disciphnary action by professional so- 
cieties and state agencies, or it may have consequences less direct 
but certainly very damaging to the accountant in the form of judg- 
ments under the Civil Liability sections of the law." A determina- 
tion by the SEC that the certificate of an auditing firm contains in- 
accurate and misleading statements throws open the legal doors to 
damage suits against the accountant by parties who have suffered 
losses on securities to which the certificate related. 

In most cases the Commission has limited itself to criticism of the 
accountant; the burden of guilt where the registration statement has 
been found to contain false and misleading statements has usually 
fallen on the company management alone. But in 1948, the Commis- 
sion made such a finding with respect to the accountant's certificate 
in the Drayer-Hanson case. Pertinent excerpts from that case follow: 

In order to acquaint shareholders with the HabiUties imposed by the Securities 
Act, we will briefly discuss the applicable provisions of the Act. . . . 

Speaking generally, Section 11 of the Securities Act creates a right of action 
upon the part of an investor to recover damages he may have suffered as a 
result of his investment if he can prove that as of its effective date the registra- 

1 Securities and Exchange Commission, Securities Act of 1933, Release No. 3277, 
March 18, 1948. 

2 See case CAP 72 entitled "Authority of the Securities and Exchange Commission 
to Discipline Public Accountants Under the Securities Act of 1933 and the Securities 
Exchange Act of 1934." 

71 



72 INTERNAL CONTROL AND INTERNAL AUDIT 

tion statement pertaining to the security which he acquired contained material 
misstatements of facts or omitted material facts necessary to be stated in order 
to make the facts stated not misleading. It is not necessary for the investor to 
prove that he acted in reliance upon such mistatements or omissions. The right 
of action exists against (1) the company; (2) every person who signed the 
registration statement; (3) any expert upon whose authority statements were 
made in the registration statement with his consent, but only in respect of such 
statements; (4) the directors; and (5) the underwriters. The company can 
defend itself against such right of action only to the extent that it can sustain 
the burden of proof that the decline in value of the investor's security was not 
the result of its misstatements or omissions in the registration statement. In 
addition to this defense which is also available to the other persons named 
above, they will not be liable if they can sustain the burden of proof that, based 
upon the standard of conduct of a reasonably prudent man in the administration 
of his own affairs, they, after reasonable investigation, had reasonable ground 
to believe and did believe at the time the registration statement became effective 
that the statements therein were true and that there was no omission of material 
facts necessary to be stated in order to make the facts stated not misleading. 



The pre-war and wartime record of earnings of the company's predecessors, 
recomputed on a corporate basis, were insufficient in any year prior to 1945 to 
cover the dividend requirements on the Class A shares which would have been 
outstanding after giving effect to the financing.^ In the course of the negotiations 
between the company and Maxwell, Marshall & Co., an oral understanding was 
reached to the effect that the bankers would not undertake the financing opera- 
tion unless the result of an audit by Barrow, Wade, Guthrie & Co. of the financial 
statements of the partnership for the ten months ending April 30, 1946, com- 
puted as though the partnership had been a corporation, indicated net income 
at least equal to one and one-half times the annual dividend requirement on all 
of the Class A shares which would be outstanding after giving effect to the sale 
of approximately 80,000 shares of Class A stock to the public. The underwriting 
house also stipulated that the audited balance sheet of the partnership as of 
April 30, 1946, must show a net worth to be transferred to the companv 
of at least $250,000. 

An audit by Barrow, Wade, Guthrie & Co. of the partnership accounts as of 
April 30, 1946, represented the partnership net worth to be approximately 
$260,000. Similarly such audit represented net earnings of the partnership for 



3 Annual dividend requirements on the 100,000 Class A shares which were to be 
outstanding amounted to $60,000. Net income of the predecessor corporation for the 
period 1936 to 1944, inclusive, and for the six months ended June 30, 1945, were as 
follows : 



Year 


Net Profit (Loss) 


Year 






Net Profit (Loss) 


1936 


$ (4,144.69) 


1941 






16,418.57 


1937 


(20,395.42) 


1942 






17,622.97 


1938 


(5,777.69) 


1943 






7,201.22 


1939 


986.47 


1944 






26,914.10 


1940 


9,011.45 


Six months ended 








June 


30, 


1945 


25,922.09 



DRAYER-HANSON, INCORPORATED 73 

the ten months ended April 30, 1946, to be approximately $181,000 for the 
partnership, and approximately $91,000 when computed as though the partner- 
ship had been a corporation. The latter amount was slightly in excess of one 
and one-half times the annual dividend requirements on all of the Class A 
shares which would have been outstanding if all of the Class A shares to be 
offered publicly were to be sold. The prospectus, following its summary of earn- 
ings, specifically stated the annual dividend requirements to be $60,000. 

As will appear later in this report concerning the accounting errors, the net 
worth of the company actually did not equal $250,000 and the earnings did not 
equal one and one-half times the dividend requirements. Sales of the Class A 
stock ceased on April 16, 1947. These accounting errors were ascertained in 
June of 1947. 

Between December 16, 1946, and April 16, 1947, a total of 59,030 shares 
of Class A stock out of the 80,529 shares offered by the company and Maxwell, 
Marshall & Co. were sold to the public. 

Some time in June of 1947 the company and its auditors, Barrow, Wade, 
Guthrie & Co., informed us that the company's controller had discovered an 
error had been made in the balance sheet as of April 30, 1946, and the partner- 
ship income statement for the ten months ending that date, certified by Barrow, 
Wade, Guthrie & Co. and contained in the registration statement and prospectus. 
The error consisted of an over-statement of approximately $97,000 in an in- 
ventory item designated "work in process and fabricated parts." This resulted 
in an over-statement of the partnership net worth at April 30, 1946, and partner- 
ship net income for the ten months ended April 30, 1946, in the same amount. 
The error in the earnings computed as though the partnership had been a 
corporation, for the ten months ended April 30, 1946, was an over-statement of 
approximately $30,000. 



Misrepresentations and Omissions in the Financial Statements of the 
Company and Its Predecessors and in the Certificate of the Independ- 
ent Accountants. 



The balance sheet of Drayer-Hanson (a co-partnership) as of April 30, 1946, 
and the pro forma balance sheet of Drayer-Hanson, Incorporated (successor 
to the co-partnership), as of May 1, 1946, which were certified to by Barrow, 
Wade, Guthrie & Co. (hereinafter referred to as the auditors), and made a part 
of amendment No. 8 to the registration statement filed by the registrant in- 
cluded under the caption "Inventories" an item "Work-in-process and fabricated 
parts— $244,331.60." With respect to this item the auditors' certificate dated 
August 5, 1946, contains the following paragraph: 

"We were present only during the taking of a physical inventory, which 
did not include work in process, as at March 31, 1946, and satisfied ourselves 
as to the procedures followed in the determination of inventory quantities as 
of that date. We were not in attendance at the physical count of the in- 
ventories taken at the close of each of the years 1942, 1943, and 1944, and 
we were informed that such procedures were not performed bv any other 
independent public accountant. In the absence of a physical inventory at 



74 INTERNAL CONTROL AND INTERNAL AUDIT 

work in process at March 31, 1946, we subsequently made test inspections 
of selected items to assure ourselves as to the existence of the inventory and 
the adequacy of the related accounting data. The inventories at the close of 
each of the years 1942 and 1944 were reviewed by us as to the basis of 
pricing and clerical accuracy and we inquired into the methods used by the 
corporation employees in determining physical quantities to ascertain that 
methods were employed which would assure reasonable accuracy. We were 
informed that an inventory was taken as at December 31, 1943, but we were 
advised that such inventory was lost and therefore not available for our 
inspection. We were informed that no physical inventory was taken as of 
June 30, 1945. On the basis of the examinations and tests made by us, we 
have no reason to believe that the inventories as set forth in the accompanying 
statements are unfairly stated." 

In May, 1947, representatives of the registrant reported to the auditors that 
they believed that the part of the inventory represented by work-in-process as of 
April 30, 1946, was over-stated by approximately $97,000. Thereupon the 
auditors made a further examination of work-in-process inventory, and as a 
result concluded that there was an over-statement of $85,313.97,^ or approxi- 
mately one-third of the net worth of the co-partnership, and an over-statement 
of like amount in the Net Income ($181,500) shown by the Profit and Loss 
Statement of the co-partnership for the ten months ended April 30, 1946, in- 
cluded in the registration statement. 

The error in the work-in-process inventory resulted principally from the 
failure of the registrant to give effect to all partial shipments on the job cost 
sheets from which the work-in-process inventory was compiled and on the 
general ledger. 

A brief description of the method of accounting for work-in-process and in 
particular partial shipments will aid in understanding how the above described 
error occurred. 

The registrant, a manufacturing concern, operated what purported to be a 
job lot cost accounting system. Under this system of accounting costs of raw 
materials, labor, and overhead relating to jobs in process were accumulated on 
job cost sheets maintained in the cost accounting department. Until such time 
as a job was complete the applicable job cost sheet did not contain anv data 
with respect to quantities. Factory operations were controlled bv production 
orders issued by the production and control departments. Such production con- 
trol consisted in keeping a statistical record of the production orders issued, 
the number of units required to be manufactured, and the number of units com- 
pleted on each production order and their disposition. 

It was the practice of the registrant to make partial as well as complete de- 
liveries of job orders both to customers and to stock, and it appears that the 
records pertaining to these transactions were maintained properly in the produc- 
tion and control department. However, the job cost sheets maintained in the 
cost department in some instances were not relieved of the accumulated costs 
applicable to partial deliveries, either to customers or to stock, until the entire 
job was completed. 

^ According to the report of Thomas & Moore . . . the o^'er-statement amounts to 
$89,097.79. 



DRAYER-HANSON, INCORPORATED 75 

On March 31, 1946, a physical inventory of raw materials, fabricated parts 
and finished goods was taken by the registrant and observed by the auditors. 
However, no physical inventory of work in process was taken; instead, a list 
showing the accumulated cost of each job in process was prepared by the 
registrant. The total of this list, $219,501.96, was found to be $54,189.09 less 
than the work-in-process inventory of $273,691.05 shown by the general ledger. 
The registrant then made an adjusting entry, bringing the work-in-process 
account on the general ledger into agreement with the adjusted accumulated 
cost of the production orders in process as shown by the list. 



. . . the registrant's determination not to take a physical inventory of work in 
process as at March 31, 1946, was not objected to by the auditors. 

The determination not to insist upon a physical inventory of work-in-process 
as at March 31, 1946, was made by Henry H. Dalton, manager of the Los 
Angeles, California, office of the auditors, on March 27, 1946, after a discussion 
with M. J. Burke, an officer of the registrant who represented that the registrant 
maintained a job cost system, pursuant to which Dalton inspected "the book- 
keeping machine which maintained the cost. And . . . [he] made a cursory ex- 
amination of these records" which took "about 30 minutes." He made no in- 
quiries concerning the registrant's system of internal control, and no tests which 
would indicate whether the alleged job cost system was adequate or whether 
it was actually in operation. 

Everett L. Mangam, a senior accountant on the auditor's staff, assumed direct 
charge of the audit. . . . He found, among others, the following "deficiencies": 
(1) there was no tie-in between units in the plant and the dollar amounts of 
inventories; (2) the raw material account was not supported by a detailed 
stores record in dollars; (3) the segregation of material in the plant was not 
entirely adequate; (4) requisitions were not being prepared for all material 
withdrawn from stores and frequent retroactive requisitions "necessary ... to 
bring the costs up to the proper material consumption" were noted; (5) no 
record was kept in the accounting department or the cost department of the 
units manufactured to date; (6) while a job was still open, the applicable job 
cost sheet in the cost department would not show how many units had been 
produced, or shipped, applicable to that job to any particular date; (7) no 
record was kept on the job cost sheets of units and dollars transferred to finished 
goods either for partially or entirely completed jobs; and (8) many instances 
were noted where no record was made on the job cost sheets of partial ship- 
ments, either to customers or stock. He concluded that there was "necessitv for 
the revision of the cost system in general" but he, nevertheless, believed that 
he would be able to use alternative procedures to assure himself with respect 
to work-in-process "that the inventory was there." He did, however, express 
concern "because of the additional responsibility and the amount of difficulty 
in making an examination of an inventory where a physical inventory is not 
available for a check" and indicated his feeling that, under the circumstances, 
"to get an exact picture of the work-in-process" he "would have to review verv 
carefully almost all of the [open] jobs" of which, he stated, there were approxi- 
mately 300 as at March 31, 1946. 

The audit procedures employed by the auditors to satisfy themselves as to 



76 INTERNAL CONTROL AND INTERNAL AUDIT 

the correctness of the list, purported to be the work-in-process inventory as at 
March 31, 1946, presented to them by the registrant were as follows: 

1. Approximately 75 (out of approximately 300) of the production orders 
in process at March 31, 1946, were examined to determine the amounts of raw 
material which should have been charged to each job and the applicable job 
cost sheets in the cost department were examined to make sure that the ma- 
terials were in fact so charged. 

2. They "made an attempt to remove all of the non-productive jobs or the 
jobs which were not in process for the purpose of producing a product which 
could be sold or a part which could be used later in the product which would be 
sold." 

3. They "inquired regarding the method of accumulation and the method of 
removing the partial shipments shown therein," and 

4. They made a physical test of work-in-process on May 8, 1946, "in an 
effort to ascertain whether the balances at April 30 were reasonable." 

Concerning the scope of this physical test, Mangam testified in part as 
follows: 

". . . Since the balance sheet was to be dated April 30, 1946, and since the 
work-in-process listing at March 31, 1946, was merely a book Hsting, we 
decided to use the listing of work-in-process jobs at April 30, 1946. We 
therefore were obliged to check the entries and transactions for the month 
of April as they affected work-in-process. We were also obliged to prepare 
our own list of costs applicable to open jobs in work-in-process because the 
company did not run a list of its own at that date. We used that list prepared 
by us as of April 30th as a basis for all of our subsequent checks on work-in- 
process balances. 

"We also, on May 8th, spent approximately one day in the plant testing 
items in various departments by observation or actual count. We were ac- 
companied at that time by the production control manager. We tested the 
result of our inspection tour against the records of the production conti'ol 
department. - 

"The work sheet shows that we checked 17 job orders. ... I believe there 
were approximately 300, 1 haven't counted them. ... It appears that the total 
accumulated cost on the job orders checked by us was approximately $70,000. 



"Two of us selected items in the plant which were in process. We reconciled 
the balances which we found in production with the records kept in the 
production control department. We referred to the job order to see that there 
was a job order, and we made subsequent reviews of the cost to see that the 
cost was normal for the particular unit being produced, that the requisitions 
were properly applicable thereto, and that the labor charges were also proper. 



"We went through the plant, starting at the primaiy departments, and 
selected various jobs in process in that department at that time. We would 



DRAYER-H ANSON, INCORPORATED 77 

select large items, count them, get a description of them, obtain the job 
number to which they applied, and make a note of it on our sheets, and 
move on to another department to select items in that department by the 
same method. 



"We believed that at March 31st the partial shipments had been recorded 
against the accounts, against the open job orders. We believed that the ad- 
justing entry in April [see below] was wholly a means of correcting a situa- 
tion in which the company found itself at that date, where they had to have 
a proper classification of inventory. 



"The tests indicated that partial shipments had been made. On the basis of 
our tests, we estimated approximately how much of a credit we need for 
partial shipments." 

These procedures disclosed no differences warranting adjustment, and no 
change was made, in the amount of work-in-process as shown by the list 
originally prepared by the registrant. 

As stated previously, the registrant found it necessary to make periodic 
entries, substantial in amount, adjusting the work-in-process account on the 
general ledger. Such an entry credited approximately $31,000 to work-in- 
process and charged a like amount to finished goods as at April 30, 1946. The 
auditors saw this entry and considered its purpose to be "to bring the finished 
goods inventory account into agreement with a physical inventory taken on 
April 30, 1946, of finished goods, and to transfer the excess credit in that 
account to work-in-process. The credit was to represent the amount of partial 
shipments or the estimated cost of the partial shipments made from jobs still 
open in work-in-process account ... It indicated to us that the system of credit- 
ing work-in-process for the month of April was not satisfactory; it represented 
a stop gap entry." 

Notwithstanding the purported nature and amount of this entry, the auditors 
did not analyze the entry or even check into the supporting work papers. 
Furthermore, there were similar adjusting entries, involving substantial amounts, 
recorded in August and October 1945, and in January, February, and March 
1946. They likewise did not attempt to analyze or to verify the correctness of 
these entries. 



In our opinion the taking of a physical inventory of work-in-process at the 
time other inventories are counted is, except in rare instances, a necessity. We 
can find no extenuating circumstances which might justify the failure of the 
registrant in this instance to take such an inventory as at March 31, 1946. In- 
deed, in light of the conditions which, as shown by the record, existed as at that 
date there was a demonstrated need for a complete and painstaking inventorv. 

It seems clear, also, that the representatives of the auditors should have made 
a more thorough examination of the registrant's system of internal control and 
its cost system, and should have determined that they were being operated 
effectively before acquiescing in the omission of a physical inventory of work- 
in-process as at March 31, 1946. And once they found, as they did in the course 
of their examination, that there was, in fact, no effective system of internal 



78 INTERNAL CONTROL AND INTERNAL AUDIT 

control and the alleged job cost system existed more in theory than in fact, they 
should have insisted that a work-in-process inventory be taken as at April 30, 
1946. Notwithstanding these conditions the company represented that there was 
in operation a controlled job cost system ^ and the auditors represented in their 
certificate that they satisfied themselves as to the adequacy of such system 
and the dependability of the company's system of internal control.^ We find 
these misrepresentations to be misleading/ It seems to us, however, that the 
auditors' dereliction in these respects is overshadowed by the inadequate manner 
in which they employed alternative auditing procedures in the absence of a 
physical inventory. 

As stated previously, they had grave doubts as to the dependability of the 
registrant's cost system, particularly with respect to the accounting for partial 
shipments, yet they failed to check, even by test, any of the individual job cost 
sheets from which the list purported to represent work-in-process as at March 
31, 1946, was prepared, to determine that accumulated costs applicable to 
partial shipments had been eliminated. Nor did they make such a check as at 
April 30, 1946. In fact the accumulated cost of approximately $20,000 shown 
for one of the jobs included in the physical test check of 17 jobs as at April 30, 
1946, referred to on page 29, was found (in the subsequent re-examination made 
in May 1947) to have been over-stated approximately $13,000 due to the 
failure to eliminate costs applicable to partial shipments. 

There can be no doubt that the auditors knew of the registrant's practice of 
making partial shipments for, as stated on page 28, they "inquired regarding . . . 
the method of removing partial shipments shown . . . [from the job sheets]." 
Furthermore the periodic journal entries referred to on page 31 [page 77 in 
this book] which effected adjustments with respect to partial shipments were 
seen by the auditors although they failed to grasp their significance for they 
did not even examine into the supporting work papers. 

It would not have been an involved procedure to test check the job cost 
sheets to determine that partial shipments had been accounted for properly. It 
meant merely the scrutiny of the production orders maintained in the produc- 
tion and control department, or a representative number of them to determine 
whether partial shipments were indicated thereon, and the examination of the 
applicable job cost sheets in the cost department to see that they were relieved 
of the accumulated cost with respect to the partial shipments. No such pro- 
cedure was followed, however. 

Under these circumstances we think it clear that the statement in the certifi- 



5 Note "B" to the Notes to Financial Statements stated "an inventory of work-in- 
process and fabricated parts has not been taken, the amounts on the balance sheet as 
at April 30, 1946, and September 30, 1946, being the accumulated cost of all work- 
in-process at the respective dates determined from the individual job cost records 
as controlled by the general accounts," 

•' The certificate, dated August 5, 1946, stated ". . . we have reviewed the systems of 
internal control and the accounting procedures , . . and . . . have examined or tested ac- 
counting records . . . and other supporting evidence by methods to the extent we 
deemed appropriate." 

7 Statement No. 1 issued in October, 1939, by the Committee on Auditing Procedure 
of the American Institute of Accountants states, on page 9, "Ob\ iously, also, it would 
be erroneous to mention internal control if none existed." 



DRAYER-HANSON, INCORPORATED 79 

cate of Barrow, Wade, Guthrie & Co. pertaining to the financial statements as 
at April 30, 1946, which was included in the registration statement— that 
". . . [the auditors] have no reason to believe that the inventories as set forth in 
accompanying statements are unfairly stated"— is entirely without justification. 
It is our conclusion that here again as we stated with reference to the audit- 
ing procedures followed in another case ". . . [the accountants'] failure to dis- 
cover the gross over-statement of assets and of earnings is attributable to the 
manner in which the audit work was done. In carrying out the work they failed 
to employ the degree of vigilance, inquisitiveness, and analysis of the evidence 
available that is necessary in a professional undertaking and is recommended 
in all well-known and authoritative works on auditing." ^ 



The company has agreed to mail a copy of this report to each person who 
purchased Class A stock offered pursuant to the registration statement. Since 
the essential purpose of the Securities Act, to insure disclosure of information 
adequate to inform investors of their rights, would appear in this case to be 
accomplished by the distribution of the report, we have determined not to 
employ the more usual remedy, i.e., the institution of proceedings under Section 
8 (d) of the Securities Act to suspend the effectiveness of the registration state- 
ment. . . . 

The company is also forwarding to such Class A shareholders for their con- 
sideration a proposed plan for its financial rehabilitation. As an aspect of such 
plan each Class A shareholder who assents to it is required to release the com- 
pany, its directors and officers, the independent certified public accountants and 
the underwriters and others from any liability such persons may have to such 
shareholders at common law or under the Securities Act of 1933 or other statu- 
tory law. The plan will become effective only if accepted by the holders of at 
least 85% of the Class A shares sold by the company to the public.^ On the 
basis of the information contained in this report and the information supplied to 
him by the company in respect of its proposed plan, each shareholder will have 
to use his own business judgment in evaluating the merits of the plan to him as 
against the possibility of effectively enforcing by legal proceedings the possible 
liability to him at common law, under the Securities Act of 1933 or other statu- 



8 In the matter of McKesson h- Rohhins, Inc.: Report on Investigation (p. 443). 

9 The more important provisions of the plan are these: Each holder of Class A 
shares is to release the company, the underwriters, the certified public accountants, 
the directors and officers and others from all liability to him under the Securities Act 
or otherwise. Subject to the procurement of such releases from the holders of at least 
85% of the Class A shares, Barrow, Wade, Guthrie & Co. has agreed to pay $87,500 
to the company; 3 directors have agreed to invest $50,000 in Class A shares of the 
company; and Maxwell, Marshall & Co. has agreed to loan $50,000 to the company, 
the loan to be evidenced by a note due in 5 years. Unsecured creditors of the company 
holding claims of approximately $319,000 out of a total of $358,808 of such claims 
have agreed, if the plan becomes effective, to accept payment of 25% of their claims 
within 90 days after the plan becomes effective and to accept payment of tlie balance 
of their claims in installments payable within one year. However, five of the largest 
creditors (holding more than two-fifths in amount of unsecured claims at January 31, 
1948) have also agreed that, as to their own claims, they will further modify tlieir 
demands to the extent that, after payment to them of the initial 25%, the balance 
owing to them need only be paid out of profits of the company. 



80 INTERNAL CONTROL AND INTERNAL AUDIT 

tory law, which may exist upon the part of the company, its directors and 
officers, the underwriters, the certified pubHc accountants, and others. We 
wish to emphasize that we have not passed upon the merits of this plan. We 
have no furisdiction so to do. No one can represent that we have made any de- 
termination whatsoever in respect of the pi 



an. 



Why were the company officers not aware that work-in-process in- 
ventories were over-stated? 

Why did the procedure followed by the public accountants fail to 
uncover this error? 



case 



lO 



ALGONQUIN RUBBER COMPANY 

Control of Repair and Capital Costs 

This case deals with the efforts of top management of a medium- 
sized company to develop effective controls over the authorization 
and expenditure of funds for repair costs and capital expenditures. 

For some time, Mr. Robert L. French, treasurer of Algonquin 
Rubber Company, had been closely involved with the financial and 
general management problems created by a program of expansion 
and diversification to which the company was committed. The in- 
creasing need for cash led to borrowing and financing by various 
means and made good control over expenditures of all kinds more 
important than ever before. That the larger number of people in- 
volved and the increasing number and variety of activities greatly 
complicated the problem of control seemed to be of no concern to 
the other officers of the company, who felt that the present methods 
of control were adequate. Mr. French, however, was becoming more 
and more concerned with the specific problem of controlling repair 
and maintenance costs and capital expenditures. He was, therefore, 
in January, 1949, reviewing the present system with an eye to its 
weaknesses and with the objective of charting for himself a course 
of action which would result in better control over the cost of these 
activities. 

Mr. French was appointed treasurer of Algonquin Rubber Com- 
pany in October, 1948. Previously he had served the company as 
assistant to the president, performing many duties that were of con- 
siderable importance in the company's operations but did not entail 
line responsibility. One such assignment was an original study of 
costs involved in the production of a line of products involving 
plastics as a rubber substitute. Another was to assist the president in 
the preparation of a five-year plan of operation for the compan\\ 
The assignment involved analyzing market prospects by product 
lines for five years in the future, projecting sales and profits for five 
years, and balancing capital requirements for future expansion 

81 



82 INTERNAL CONTROL AND INTERNAL AUDIT 

against the availability of funds from plowed-back profits, noncash 
expenses, such as depreciation, and additional capital from outside 
the company. 

Company History and Products 

Algonquin Rubber Company, located in a medium-size Midwest- 
ern city, manufactured for many markets a wide variety of rubber 
products ranging from multipurpose mechanical rubber products to 
such products as garden hose and sponge rubber. The company had 
been organized in 1907 with a capitalization of $235,000. Its original 
products, developed in its own research laboratories, were special- 
ized moulded products of which rubber was a basic ingredient. The 
steady development of new products over the years, always with 
stress upon high quality and uniformity, had resulted in rapidly 
expanding markets and sales both in the United States and abroad. 
Sales had maintained their sharp upward trend during World War II 
because many of the company's products were needed by the armed 
forces; and they continued to rise from 1944 to 1948, because the 
company was not faced with any serious reconversion problems at 
the end of the war. The following figures, taken from annual reports, 
present the company's gross sales and net earnings for selected years : 

Year 
1924 
1929 
1934 
1939 
1944 
1948 

A substantial portion of Algonquin's sales was made abroad to 
customers in most of the countries in the world with the exception 
of certain Eastern-bloc nations. There were four Algonquin company 
plants in foreign countries, each organized as a subsidiary company. 

In 1949 four plants were in operation in the United States, serving 
all 48 states. Two of the plants were in a Midwestern city, one in 
New Jersey, and one in Fresno, California. In early 1949 the total 
number of employees was approximately 1,375. 

Emphasis was placed on expansion of the business through diver- 
sification of products and markets, achieved by means of an active 
research and development organization within the company. Re- 
search expenditures were normally 5 per cent of sales. 



Gross Sales 


Net Earnings 


$ 504,696 


$ 24,985 


2,215,481 


183,064 


3,702,419 


247,188 


5,512,672 


642,935 


10,873,549 


627,634 


16,211,246 


731,686 



ALGONQUIN RUBBER COMPANY 83 

Algonquin manufactured and sold a wide line of moulded and 
extruded items of natural and synthetic rubber and plastic material. 
Founded originally to furnish special moulded rubber products for 
the nearby automobile industry, the company had expanded its 
line to include conveyor and transmission belting, industrial and 
garden hose, and moulded parts for manufacturers of textile and 
printing machinery. Many of these latter parts were developed by 
technical personnel of Algonquin Rubber Company and replaced 
nonrubber or nonplastic materials. 

As a result of its experience in the rubber industry and its auto- 
motive connections, the company became a major supplier of ad- 
hesives for the automobile companies, later branching out to supply 
rubber- type adhesive to all industries. It prided itself on its ability 
to supply products specifically engineered for intended end-uses. 
This line of products had required establishment of two small plants 
to give service demanded by customers in areas far from the exist- 
ing plant. 

The advent of synthetic rubber and plastics had also resulted in 
further diversification of the company's line. The company rapidly 
became a major producer of garden hose manufactured from poly- 
vinyl chloride. With the experience so gained it entered the field of 
vinyl sheeting for rainwear, shower curtains, and other similar uses. 
Because it was among the first companies to enter this field it was 
able to develop an attractive market before the field became highly 
competitive. 

Company Organization 

In discussing his company's organization, Mr. French said that 
formal organization charts were avoided as a result of the policy of 
Mr. Howard Patten, company president. The reason for this policy, 
according to Mr. French, was to maintain and strengthen the per- 
sonal relationship among management leading to informal consulta- 
tion in the development of decisions. It was also a policy of the 
president, Mr. French said, to "let the man make his job." Avoidance 
of formalized lines of authority and rigidly defined duties, it was 
believed, would allow a man to perform functions in line with his 
abilities. 

The company did have, however, a group of officers concentrating 



84 INTERNAL CONTROL AND INTERNAL AUDIT 

in certain areas of management. Besides the president, there was an 
executive vice-president, who had at one time served as treasurer, 
prior to Mr. French's own predecessor. There were also a vice-presi- 
dent in charge of manufacturing; a vice-president for domestic sales; 
a vice-president for foreign sales; a vice-president in charge of re- 
search; an executive in charge of development, who worked closely 
with the president; a vice-president who was chief engineer; a vice- 
president concentrating on the development of polyvinyl chloride 
sheeting, the most recent addition to the company's line of products; 
and a vice-president for legal matters. Other top executives included 
the treasurer, a purchasing officer, and a personnel officer. 

The board of directors was made up of fourteen men, of whom 
six were officers. Mr. French was not a member of the board. Five 
directors were major executives in manufacturing companies, and 
three were executives of investment trusts. The latter, however, rep- 
resented themselves, and not the investment trusts for whom they 
worked. 

An executive committee, which stemmed from the board of direc- 
tors, was part of the company's management structure. The commit- 
tee consisted of the president, the executive vice-president, and four 
other directors. When Mr. French was appointed treasurer, he be- 
came secretary of the executive committee. 

Functions of the Treasurer 

The by-laws of Algonquin Rubber Company defined the treas- 
urer's function as follows: 

Article IV— Officers other than Directors 

Section 5— Treasurer— He shall have custody of and responsibility for all 
monies, books and accounts, subject always to the control of the Board of Direc- 
tors. He shall sign certificates of stock. He shall deposit in the name of the 
company all funds of the company which may come into his hands in such bank 
or banks or other depository as the Board of Directors may indicate. He shall 
pay out such monies as the business requires, taking proper vouchers therefor. 
At each Annual Stockholders Meeting, he shall present a full statement of the 
financial afl^airs of the company. He shall do and perform all other acts incident 
to his office. The bonding of the Treasurer for the faithful performance of his 
duties shall be left to the discretion of the Board of Directors.^ 



1 The company carried a blanket bond covering all its employees. The treasurer 
was included under this bonding arrangement. 



ALGONQUIN RUBBER COMPANY 85 

The only other reference to the treasurer in the by-laws of the 
corporation dealt with his election. On this score, the by-laws or- 
dered the election of the treasurer by the stockholders using a closed 
ballot. The only other officer so elected was the secretary. Mr. 
French, as stated previously, took office in October, 1948. For about 
two months before that time he had worked unofficially under the 
preceding treasurer to familiarize himself with the functions of the 
office. Mr. French and his predecessor were close personal friends, 
who kept each other informed of their respective problems and, in 
the words of Mr. French, "used each other as consultants." Mr. 
French said that his friendship with his predecessor, which had 
started in Washington in 1941, and their frequent discussions of 
work problems gave him a familiarity with the nature of the treas- 
urer's function at Algonquin Rubber Company before his appoint- 
ment to that post. 

When Mr. French took office, the treasurer's department consisted 
of the treasurer, two assistant treasurers, and a controller, each with 
their respective staffs, totaling 45 employees. One of the assistant 
treasurers concentrated on taxes and problems of foreign financial re- 
lations and worked with the controller on accounting methods. The 
other concerned himself with problems of customer credit, pension 
plans, and the company's insurance coverage; he was also respon- 
sible for the management of the company's cash position, which 
involved among other duties the preparation of daily cash reports 
and the transfer and deposit of funds among several domestic banks. 
The controller was in charge of accounting, which included the 
preparation and interpretation of monthly statements (profit and 
loss, balance sheet, cost, sales, etc.) and other reports for man- 
agement. 

There was considerable consultation among the executives in the 
treasurer's office, according to Mr. French. For example, the assistant 
treasurer who was concerned with accovmting methods and foreign 
exchange discussed with Mr. French and the controller the problems 
of making accounting reports more useful and of educating manage- 
ment in the use of these reports. 

Although he delegated the specific functions mentioned above to 
the three major executives in his department, Mr. French kept 
abreast of their activities. The problem of making accounting re- 



86 INTERNAL CONTROL AND INTERNAL AUDIT 

ports more useful, for example, was one in which he was particularly 
interested. He also joined the company's auditors and the assistant 
treasurer in charge of accounting methods in consideration of the 
problems that arose in connection with closing the books and the 
year-end reports. Mr. French examined regularly the daily cash 
position report and discussed it with the assistant responsible for the 
company's cash position; the two men together determined any 
necessary action. An example of action arising out of such a discus- 
sion was the purchase of short-term government securities because 
the company appeared to have an excess of cash for its short-term 
needs. Another way by which the treasurer kept informed of the 
work of one of the assistants was through the exchange of copies of 
all correspondence passing over their respective desks. Mr. French 
stated that this exchange, carried out on a highly informal basis, was 
a very useful device for keeping him informed. 

At the beginning of each half-year Mr. French presented to the 
board of directors a projected profit and loss statement for the com- 
ing six-month period. Each January he presented for board approval 
an annual capital expenditures budget, including plant expenditures, 
which had been worked out by the major executives in consultation. 
The typical capital expenditures budget included both appropria- 
tions for new capital projects and continuing appropriations for 
capital projects already under way, which thus were reviewed by the 
board at the beginning of every year. Mr. French also met with the 
board or the executive committee monthly to present the monthly 
financial statements, interpret them, and answer questions. 

Each week Mr. French and the other department heads attended 
a meeting conducted by the executive vice-president for the purpose 
of keeping the department heads informed of the activities in each 
department. 

Another weekly meeting attended by Mr. French was of the shop 
order committee, which consisted of the executive vice-president, 
the treasurer, the head of the development department, the vice- 
president in charge of manufacturing, the chief engineer, and the 
vice-presidents in charge of research and sales. According to a policy 
established earlier in the company's history and applying to all 
plants in the United States and abroad, all capital expenditures ex- 
ceeding fifty dollars in cost, and repair and maintenance jobs, other 
than those of a routine nature, had to be approved by this committee 



ALGONQUIN RUBBER COMPANY 87 

before the work was undertaken. Cost was defined as material and 
direct labor expenses, excluding any allocations of overhead. 

Parts A and B below describe in some detail the development of 
a specific capital project and the handling by the shop order com- 
mittee of requests for repair and maintenance jobs and capital ex- 
penditures. These illustrations involve decisions that were long since 
made, and Mr. French was reviewing them not to determine whether 
the correct decisions had been reached but to discover if the system 
of control was adequate to achieve its purpose and also to assist him 
in discovering by what means he could bring about change if and 
where indicated. 

A. A CAPITAL PROJECT 

For management purposes, the management of Algonquin Rubber Company 
defined a capital project as a major program involving either the expansion or 
modernization of facilities for the producton of existing lines or the develop- 
ment of equipment for the production of new product lines that had passed 
through the stages of research and development and were ready for maiketing. 
A capital project was clearly distinguished from a capital equipment purchase 
of a smaller nature that did not entail a major policy decision on product lines 
and marketing. 

The executives who were immediately involved in a capital project were the 
president; the executive vice-president; the vice-president for research; the vice- 
president for engineering, i.e., the chief engineer; the head of development, 
who reported directly to Mr. Patten; the vice-president in charge of manu- 
facturing; the vice-president in charge of domestic sales; and the treasurer. 
One of the most important aspects of the managerial process in the develop- 
ment of the capital project was the informal nature of the executives' actions 
and their relations with one another. 

When Mr. French joined the company in 1946, the research department 
and the development department were investigating the qualities and uses of 
various plasticizers, which were becoming significant in connection with new 
products manufactured by the company from both synthetic rubber and 
plastics. Management visualized that plastic garden hose, vinyl sheeting, and 
many of Algonquin Rubber Company's other products involving the use of 
plasticizers would continue to show substantial sales growth. 

The company had two alternatives for obtaining plasticizers: (1) it could 
purchase its needs from existing manufacturers, or (2) it could undertake their 
manufacture. A comparison of costs of manufacture in the company's own 
plant and costs of purchasing from outside suppliers would be one factor 
influencing the choice between the alternatives. A minor consideration was the 
possibility of added income from the sale of excess quantities of plasticizers if 
they were manufactured in the Algonquin Company plant and sold to other 
manufactm-ers. A further important consideration was the quality of the 
product when manufactured and controlled in the company's own plant, in 



88 INTERNAL CONTROL AND INTERNAL AUDIT 

comparison with the quality of the product purchased from outside suppliers. 
Finally, the problem had to be examined in the light of the company's entire 
plastics program. Underlying all these factors was an analysis of the future 
market for their use. 

Estimates of the market for the new products using plasticizers, involving 
the study of such factors as demand, competitive products, and possible 
expansion, were prepared under the authority of the vice-president in charge 
of domestic sales. Mr. French's relationship to the project began at this point, 
when the vice-president in charge of sales discussed the sales estimates with 
him. Mr. French's function was that of a consultant, and, as meetings were 
held, he attempted to raise questions concerning the validity of the estimates 
in order to insure the examination of all pertinent factors. For example, one 
question he asked was whether consideration had been given to the effects of 
new techniques in the use of vinyls or the development of new and improved 
plasticizers. 

From the sales estimates for the new products it was possible to obtain a 
rough estimate of Algonquin company's plasticizer requirements. As a minor 
factor in the decision, the sales department also prepared estimates on the 
sales of plasticizers to outside manufacturers, involving the study of the market 
and competitor's sales, and the projection of an estimate as to what part of the 
market Algonquin Rubber Company could reach. 

From the sales department's estimates of the demand for the product, both 
for the company's own use and for sale to other manufacturers, the development 
department prepared estimates of the cost of manufacturing plasticizers. The 
final cost estimate for a representative product was between 21 and 25 cents 
a pound, compared with a cost of buying the material from suppliers of 36 
cents a pound. In reaching this estimate the development department included 
direct costs, such as material and labor, and any additional burdens such as 
increased electric power or indirect supervision. Allocations of existing burden 
costs were not made for purposes of this estimate. 

Mr. French entered the scene again at this point. When the head of the 
development department, who had an office adjacent to Mr. French's, wanted 
to discuss cost estimates, he dropped into Mr. French's office with a few of his 
engineers, showed him the cost figures, explained them, and asked for com- 
ments and questions. Again Mr. French was in a consulting relationship, since 
he viewed his job as one of raising questions. Although he was not prepared to 
question the detailed engineering aspects of the cost estimates, he was able to 
raise broader questions. 

The development department and the research laboratory also investigated 
the problem of how the quality of plasticizers manufactured at Algonquin 
Rubber Company would compare with that of plasticizers purchased from 
suppliers. It was soon discovered that in order to assure the deliverv of 
plasticizers of proper quality standards from outside suppliers, it would be 
necessary to give them information on the use of the material bv Algonquin 
company. Since it was intended to use plasticizers in certain new products and 
since this information would be of value to competitors and might leak out 
through suppliers, it was concluded that, if possible, manufacture of plasticizers 
should be undertaken at the Algonquin plant. 

When the sales and cost estimates were prepared, including the capital costs 
involved in setting up the manufacture of plasticizers, they were presented to 



ALGONQUIN RUBBER COMPANY 89 

Mr. Patten, the president. Mr. Patten called in top officials, including Mr. 
French, to review the sales and cost estimates. Having reviewed these figures 
previously, Mr. French was prepared to answer questions and clarify the 
estimates. The next step in reaching the decision involved further meetings of 
a group consisting of Mr. Patten, the executive vice-president, the vice- 
president in charge of domestic sales, the executive in charge of development, 
the vice-president in charge of engineering, and Mr. French. At this particular 
meeting, Mr. French said that the executives "argued about the project." 
Questions were aired and different points of view were raised, and the 
executives decided on a course of action, although there was no formal method 
of indicating approval. 

With agreement reached by this group, the matter was ready for the 
consideration of the board of directors as part of the capital expenditures 
budget for 1948. Mr. Patten, Mr. French, and the development men met to 
decide how much money should be requested from the board in the form of 
appropriations to carry out the project. Mr. French, though not a technical 
man, participated in the discussion as to how much of a safety factor should 
be included in the sum requested and, since changes to be made affected 
existing products, whether part of the amount to be expended should be 
considered to come under appropriations already made. The group then 
prepared a short memorandum outlining the project, and the sales, costs, and 
profits estimates. The board had previously been informed on a number of 
occasions that the manufacture of plasticizers was being considered by 
various executives and that development work was in process in the laboratories; 
and the board had already discussed the proposal from many angles. Therefore 
it was not necessary to present the project in great detail. With Mr. French 
present to review the figures and answer any questions, the board devoted 
several regular meetings to a discussion of the project before it finally gave its 
approval and appropriated $100,000 to the undertaking. 

At this point the engineering and development departments began the 
preparation of detailed designs for the equipment. As the design work 
progressed, engineering dockets and shop order forms were prepared for sub- 
mission through the channels and in the manner described in Part B below. 

Throughout the process of reaching the decision to undertake the major 
capital project of the manufacture of plasticizers, Mr. French had no specific 
authority of responsibility except as a member of informal committees. He 
viewed his relationship throughout the course of the discussion as primarily that 
of a consultant raising pertinent questions and assisting in every way possible. 

B. SHOP ORDERS 

The shop order committee, consisting of the executive vice-president, the 
treasurer, the head of the development department, the vice-president in charge 
of manufacturing, and the chief engineer, and the vice-presidents in charge of 
research and domestic sales met every Monday at 11:30 a.m. Besides the 
regular members, other executives were called in from time to time when the 
shop orders under consideration were of particular interest to them. As stated 
earlier, the function of this committee was to approve, for all plants, all capital 
expenditures exceeding fifty dollars in cost and repair and maintenance jobs 
other than those of a routine nature. The total amount of shop order expendi- 



90 



INTERNAL CONTROL AND INTERNAL AUDIT 



tures was in turn controlled by the treasurer, using as a control the allotment of 
funds in the capital expenditures budget, which was approved by the board 
annually. The summary of plant expenditures, which was prepared every three 
months from records kept in the treasurer's office, permitted him to report on 
progress and to assure the board that the funds appropriated had not been 
exceeded by actual expenditures. Exhibit 1 gives the six-month summary for 
the period of January 1— June 30, 1949. 

Shop orders were of three types: (1) an expense shop order, (2) an 
individual capital equipment shop order, and (3) a capital equipment shop 
order that was part of a capital project. 

EXHIBIT I 

Summary of Consolidated Plant Expenditures— January 1-June 30, 1949 
(Part of the Over-All Capital Expenditures Budget) 



Description 


Appropriation 


Expended to 
hine 30, 1949 


Balance 


Number 


Amount 


June 30, 1949 


Amount * necessary to complete 
shop orders and projects in proc- 
ess 12/31/48 


49A 


$294,800 


$197,665 


$ 97,135 


Miscellaneous routine expendi- 










tures necessary to maintain exist- 
ing lines at all plants in 1949 


49B 


220,000 


75,491 


144,509 


Changes to fire insurance protec- 










tion system at headquarters re- 
quested by fire insurance company 


49C 


22,000 


16,582 


5,418 


Added equipment at New Jersey 
plant to meet sales estimates and 










improve quality 


49D 


165,000 


127,411 


37,589 


Amount for manufacturing of plas- 










ticizers 


49E 


33,000 




33,000 




$734,800 


$417,149 


$317,651 



* To clarify company records at the beginning of each year, all unexpended monies appropriated for 
shop orders in the past year were closed out, and a new amount appropriated to complete those orders 
initiated but uncompleted in the previous year. 



7. Expense Shop Order 

Expense shop orders were largely maintenance and repair jobs exceeding $50 
in cost. Examples of this type of shop order included the replacement of a 
bearing on a rubber mill at a cost of about $200, and the replacement of pipe 
corroded by acid penetration, at a cost of $300 or more depending on the 
length of pipe involved. Another example of an expense shop order was the 
repair of a building, damaged when a truck backed into it. 

These shop orders were considered "run of the mill" orders and usually did 
not take up a large part of the committee's or Mr. French's time. In many 



ALGONQUIN RUBBER COMPANY 91 

instances, in fact, Mr. French would approve this type of order when it was 
presented to him, and send it on for action; he would inform the committee of 
his action at the next meeting of the group. Mr. French believed review of 
these orders to be wise because it gave the committee the opportunity to 
question the method of repair contemplated and to point out certain repair 
jobs recurring with unusual frequency. The committee could then recommend 
investigations of a new method of repair to reduce wear. 

2. Individual Capital Equipment Shop Order 

Shop orders of this type were designed to cover the acquisition of items of 
equipment needed to replace worn-out equipment or added to existing items 
of a similar nature, but not equipment involving a major expansion of a product 
line or in any appreciable way affecting the company's product policy. For 
example, Mr. French and the committee considered a request from the New 
Jersey plant for a new mixing kettle, estimated to cost $2,500, which was 
needed as an addition to existing kettles rather than for replacement purposes. 
The reason for the request was to enable the plant to mix two different com- 
pounds in separate kettles. It was reported by the originator that he had found 
mixing the different compounds in the same kettle resulted in contamination 
of the compounds, which further led to a deterioration in the quaHty of the 
products involved. The committee approved this request after it had determined 
that the production quantities of each compound were sufficiently large to 
warrant separate mixing kettles, and that cost savings would result from the 
fact that cleaning the kettle would no longer be necessary, since only one 
product would be mixed in it. 

3. Capitol Equipment Shop Order as Part of a Capital Project 

The capital expenditure projects submitted to the board of directors for 
approval were supported by cost estimates given only in general terms and 
not in detail. 

After the board had approved a project detailed design work and cost esti- 
mates were started. As the designs for a major component of a project were 
completed, shop order requests with estimates were submitted for the approval 
of the shop order committee. 

For example, a request was tendered for an 8,000-gallon tank, estimated to 
cost $2,900, to be used in a plant expansion project expected to cost $100,000. 
The board of directors' approval for the expenditure of the $100,000 had 
already been obtained, and an appropriation had been made for the project. 
The purposes in approving specific and relatively small parts of a capital 
expansion already approved by the board of directors, according to Mr. 
French, were to keep track of the estimated costs of component parts as 
compared with original estimates prepared before detailed design work was 
done, and to give executives opportunities to study the methods used in 
carrying out various projects. 

The procedure in getting approval on a shop order consisted of thi'ee 
steps: (1) preparation of an engineering docket form by the department 
requesting the work; (2) preliminary examination by the engineering depart- 
ment and preparation of a cost estimate; and (3) authorization of the shop 
order by the shop order committee. 



92 INTERNAL CONTROL AND INTERNAL AUDIT 

EXHIBIT 2 

Engineering Department Docket 

Requested by R. T. Hoover Dept. Dept. Head Approval P. Siveeney Date 3-21-49 

Date wanted Charge 

Building No. 54 Dept. No. 23_ 

Description of Work Desired: 

Wax line compound storage kettle No. 52 for natural rubber use, Building 54. 

Reasons for Work: ' . ^ 

Kettle No. 56, with a capacity of 6,000 lbs., and Nos. 35 and 36, with a 
capacity of 3,000 lbs. each, are now being used for mixing and storage of natural 
rubber compound SL15. These tanks have coated interiors to prevent discolora- 
tion of the compound. Because of present usage of compound SL15, which 
amounts to 10,000 lbs. per week, we are forced to use all three kettles listed 
above. Use of the small kettles 35 and 36, which handle uneconomical batch 
sizes, represents an operating loss at present production level. Cost studies are 
available to indicate that this loss approximates $45 per month. 

Available in the same area as the kettles listed above and connected ready 
for use is kettle No. 52, which has a capacity of 6,000 lbs. However, this kettle 
is not coated and hence cannot be used with natural rubber compound for fear 
of staining. The kettle should also be checked to make sure that there are no 
other parts of materials which, when they came into contact with compound, 
might result in discoloration. 



WHITE, PINK, AND YELLOW COPIES TO CHIEF ENGINEER S OFFICE 
GREEN COPY TO PERSON MAKING REQUEST 



7. Preporofion of the Engineering Dockef 

The following is quoted from the company's Standard Shop Order Procedure: 

The Originator - fills in an "Engineering Department Docket" in quad- 
ruplicate [see Exhibit 2 for a typical docket form as submitted by an 



■" Shop order requests came most frequently from the engineering, manufacturing, 
research, and development departments. Originators of shop order requests included 
plant superintendents, who might act at the request of foremen, and research and 
development engineers. 



ALGONQUIN RUBBER COMPANY 



93 



EXHiniT 2A 

Engineering Department Docket, Reverse Side 



THIS SIDE FOR ENGINEERING DEPARTMENT USE ONLY 



Written by Date 

Machine Bldg. No Floor 

Eng. Dept. Approval Date 

Dept. Head Approval Date 

S.O. Description: 



Docket No. 

Shop Order No. . 
Charge Account 
S.O. Transmitted 
Total Cost 



Reason and Remarks: 



Detail 



Classification: 


Labor 
Cost 


Cost 
Material 


Drafting Time 






Purchase 






Machine Shop 






Mechanics 






Pipefitters 






Carpenters 






Electricians 






Painters 






Laborers 






Totals 







originating office] giving all available data to assist the Engineering Depart- 
ment in obtaining a full understanding of the work proposed. This is to 
express the ideas of the Originator as fully as possible. When the form is filled 
in, it must be approved by the Department Head to whom originator of the 
request is responsible and, wherever possible, show the account to be charged 
for any costs incurred by the Engineering Department in fulfilling requests. 



94 INTERNAL CONTROL AND INTERNAL AUDIT 

In cases where emergency repair work was necessary the Standard Shop 
Order Procedure read as follows: 

Work must not be started on an Engineering Department Docket in 
advance of home office approval, unless an emergency arises which makes it 
imperative to go ahead before approval can be obtained from the home 
office. This applies particularly to Shop Order Requests covering maintenance 
and repair jobs at Outside Plants and Subsidiary Company factories. Shop 
Orders covering Plant Additions or Replacements should not be started 
before approval is obtained from headquarters.^ 

2. Approval by Engineering Department and Cost Estimate 

The Standard Shop Order Procedure described as follows the procedure for 
obtaining approval and cost estimates from the engineering department: 

Upon receipt of the three Docket copies [submitted by originator, who kept 
fourth copy] the Engineering Department will, unless otherwise directed,^ 
start work on the estimate in the same order of priority as received. A com- 
plete estimate [see Exhibit 3] will be prepared on the basis of the Engineer- 
ing Department's understanding of the job requested and the reverse side of 
the request form will be filled in by the Engineering Department. [See Exhibit 
2 A for the reverse side of the Docket form.] This will show the job details 
on which the estimate has been based and will be in as much detail as pos- 
sible or necessary for the Originator or Department Head to understand fully 
the proposed work. 

Two copies of the Docket will then be returned by the Engineering De- 
pai-tment to the Department Head who originated the request for study and 
action. If the job has been properly outlined by the Engineering Department 
and it is desired that a Shop Order be instituted, the Department Head will 
sign his approval in space provided on the reverse side of the form. 

The Department Head after approving the Docket returns two copies to 
the Engineering Department. 

3. Approval by the Shop Order Committee 

The engineering department filled out the shop order form [see Exhibit 4 
for an authorized shop order, and Exhibit 4 A for reverse side] and one copy 
of the docket was forwarded to Mr. French. All dockets had to be in Mr. 
French's hands by Friday afternoon in order to be considered at the following 
Monday meeting of the shop order committee. 

Mr. French personally reviewed all the shop orders to be studied by the full 
committee, in order to familiarize himself with the orders so that he could 
raise questions for the committee's consideration. The time taken for this review 



3 In tlie overseas subsidiaries, plant managers were permitted to initiate the work 
called for by their shop orders without prior approval where they felt such action 
necessary; they were, however, expected to inform the head office as soon as possible. 
Mr. French and the shop order committee were thus able to review such actions peri- 
odically to ascertain the number of this type of shop orders and the relationship be- 
tween estimated and actual costs. 

'^ The chief engineer and the department head together might give a request special 
priority. 



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95 



EXHIRIT 4 

Authorized Shop Order 



Algonquin Rubber Company Division Main Plant 


S. O. No. 2414 


Related Machine Orders and 
Expense Job Orders 


Recommended by Date 
R. T. Hoover 3-21-49 


Docket No. 4086 




Authorized by Date 
R. L. French 3-28-49 


Charge X4438 




Date Completed 





General Description of Work to Be Done 



Wax line compound storage kettle #52 for natural rubber use, Ruilding #54. The 
proposed work is similar to that recently done on Kettle #56, or S.O. 2342, with a final 
cost of $365.59. The agitator assembly is to be wire brushed and wax coated, and the 
bottom valve is to be replaced with a rubber-lined diaphragm valve. 



Reasons for the Work 


Cost Summary 


( 1 ) X Cost reduction— annual savings are estimated to be $ 

See below 

( 2 ) Safety ( 3 ) Improved working 

conditions 
( 4 ) Preventive maintenance ( 5 ) Repairs to maintain 

production 
( 6 ) Research or experimental ( 7 ) Productive capacity 

to meet sales 


Estimated cost 
(see over) 


375.00 


Actual cost 
(see o\ev) 




Gain loss 





(8) Other requirements 

We are presently using 42,000 lbs/month of SL15 compound mixed in one 6000 lb. 
and two 3000 lb. kettles. Kettle 52 is already connected, but it is necessary to coat the 
tank to prevent staining of the compound. If we substitute 6000 lb. batches for 2650 
lb. batches, the maximum possible in the small kettles, labor saving at present produc- 
tion is $36/month. In addition to this saving, we gain in flexibility by having small 
tanks available for new rubber compounds for which requirements are small. 



2650 lbs. batch 



6000 lbs. batch 



Standard minutes of labor per batch 450 550 

Cost at 1.40 /hr. 1050 12.83 

Cost per lb. .3964' .2144 

Savings basis 20,000 lbs. now mixed in small kettles $36/montJi 



Special Instructions and Comments 



Estimated cost of replacement item covered by this Shop Order 

Date of purchase ( ) and original cost of item to be removed from 
plant, if any 

Estimated Increase (Black) Decrease (Red) in Plant Account 



96 



ALGONQUIN RUBBER COMPANY 



97 



EXHIBIT 4A 

Authorized Shop Order (Reverse Side) 



Details of Cost Estimate and Actual Cost 



Classification 


Hour 
Estimates 


Labor 
Estimates 


Materials 
Estimates 


Total 
Estimates 


Labor 
Actual 


Materials 
Actual 


Total 

Actual 

Cost 










375.00 


128.97 


243.64 


372.61 



Green Copy to Dept.— Plant Acct. 
Blue Copy to Person Making Request. 



White Copy to Acct. Dept. after Approval. 
Yellow Copy to Branch, or Dept. 71. 
Pink Copy to Chief Engineer's Office. 

note: This form must be used to secure authorization of any construction, purchases, 
for plant account, or expense jobs estimated to cost more than $50.00. 



ranged from one hour at the lov^^ point of shop order requests (about four or 
five ) to a half -day at the peak ( thirty to thirty-five shop orders ) . 

During a committee meeting, which might last up to about three-quarters 
of an hour, each order would be read by a representative of the originator and 
questions would be raised; a discussion might ensue on the order; and then 
approval would be voted or denied. Actually, Mr. French said, there were many 
routine shop order requests which were passed upon briefly and in a matter 
of fact manner as a result of the knowledge accumulated from past experience 
as to what was a routine job, and what needed careful consideration. 

Few shop order requests that reached the committee were rejected, accord- 
ing to Mr. French. As stated previously, the requests had to be approved by the 
particular departments involved, and at times approval was denied at this 
level. Mr. French said that the committee seldom denied a shop order request 
outright. Rejection usually took the form of a return for additional data, or for 
the study of alternatives suggested at the committee meeting. 

For example, Mr. French, in conjunction with the engineering department, 
instigated a shop order request for additional meters to measure electric and 
steam usage by departments, the purpose of the meters being for cost compari- 
sons and control. The committee referred the request back to the engineering 
department for further consideration, and asked the department to study the 
possibility of using movable meters, which could be transferred from one de- 
partment to another, instead of permanent meters in all departments. The use 
of movable meters, if feasible, would require fewer meters and result in savings 
in cash outlay. Although this shop order request was not approved, it was not 
flatly denied. Mr. French believed that it would be approved after the engineer- 
ing department had completed its study of the alternative suggested b\' the 
committee and had presented the facts to the committee. 



98 INTERNAL CONTROL AND INTERNAL AUDIT 

A type of rejection that occurred from time to time was on a request for non- 
productive equipment. The committee sometimes denied such requests on the 
grounds that the existing equipment was adequate and the expense involved 
was therefore unwarranted. 

After the committee approved the orders, Mr. French signed the shop order 
form in the designated space. He then returned all copies of the approved 
shop order to the engineering department, where a shop order number was 
assigned. That depaitment would forward the blue copy to the originator of 
the request, the yellow copy to the foreman in charge of the project to initiate 
the work, the green to the plant accountant, the white to the accounting records 
staff, and retain the pink copy in the office of the chief engineer. 

The accounting department, after receiving the white copy of the shop order, 
would set up a ledger card under the appropriate shop order number. Later, as 
the foreman in charge of the work accumulated and forwarded time cards for 
labor and charges for materials each week, the ledger card would be used to 
list the pertinent charges. Upon completion of the work, the foreman would 
forward all remaining cost data. His yellow copy of the shop order was sent 
to the engineering department, which inspected the data and forwarded it to 
the accounting department. The latter department would in turn complete the 
ledger cai'd and transmit it to the engineering department for study as to the 
inclusion of all pertinent costs. If the engineering department agreed with the 
final tabulation of costs, the ledger card would be closed out by the accounting 
department and forwarded to the plant accountant. 

At the end of each month, all shop order costs, for both complete and in- 
complete orders, would be sent to the plant accountant. He then tabulated 
them and forwarded the appropriate information to the treasurer's office. Thus 
Mr. French received the data on the status of shop orders each month. 

Mr. French regarded the shop order procedure as useful for a number of 
reasons. It was a valuable device for giving him and the other members of the 
committee the opportunity to raise questions concerning the expenditure of 
company funds. It also served to put pressure on the engineering department 
to make careful cost estimates and on all parties involved to keep actual costs 
close to estimates. Mr. French kept in his desk a book in which costs for shop 
orders were entered and their totals checked against over-all shop order ap- 
propriations. In reviewing this book and the monthly report from the account- 
ing department, Mr. French frequently could spot cases where actual costs 
were running more than the allowable ten per cent ahead of estimated costs; 
and he could then raise questions that would lead to more careful estimating 
in the future, and to closer control of actual costs. In addition to the records 
maintained in his own office, Mr. French received monthly a copy of a summary 
engineering report [see Exhibit 5] showing monthly tabulations of shop order 
costs and unexpended funds for the home plant. With either this report or the 
accounting department data, Mr. French could investigate outstanding prob- 
lems through the accounting or engineering departments. Mr. French also re- 
garded the shop order system as an effective communication device, which 
enabled him and the other members of the committee to keep abreast of ac- 
tivities ranging from small maintenance jobs to major plant expansion programs. 

In January, 1949, Mr. French was considering the possibility of some changes 
in the shop order procedure. One objective would be to expedite the reporting 
of excess costs, that is, costs more than ten per cent above the estimates, on work 



ALGONQUIN RUBBER COMPANY 



99 



EXHIBIT 5 

Shop Order Report *-July 12, 1949 



The accompanying June 30 reports show summary tables of shop orders as follows: 



Schedule A— Home plant shop orders 
closed to June 

Schedule B— Cumulative effect of 
additional credits of $526.63** 
on shop orders closed prior to 
June 

Schedule C— Home plant shop orders 
in process, 6/30/49: 

Plant shop orders*** 

Expense shop orders 



Plant shop orders 
Expense shop orders 



Under-Rtins 
$ 6,730.62 

50,274.30 



Estimated 
Cost 

$83,820 

49,459 

Estimated 
Cost 

$41,616 

7,265 



Over-Runs Net Total 

$ 3,775.62** $ 2,975.00 

- 50,274.30 



Still to Be Expended 
Amount Percentage 

$27,059.59 32.3% 

29,497.94 59.6% 

Over-Runs 
Amount Percentage 

$ 3,648.65** 8.8%** 

1,309.10** 18.0%** 



* This report covers only shop orders in the home plant. The treasurer's own records, however, made 
similar data available on shop orders in other plants and in the subsidiaries. 

** Figures in red. 

*** "Plant shop orders," as used here, represented a combination of the individual capital equipment 
shop orders and the capital equipment shop orders that were parts of a capital project. 



authorized by a shop order. Though he received actual cost data each month, 
it was difficult for him to ascertain how much of an individual shop order's 
work had been completed, with the result that an order might actually exceed 
its estimated cost by the time of its completion. Mr. French was wondering 
whether any action on his part might resolve this problem. He also was giving 
some consideration to raising the fifty-dollar expense limit in order to allow 
the individual departments to spend larger sums without first getting the ap- 
proval of the shop order committee. 

Mr. French was, naturally, concerned with a great many other things besides 
the control of repair and capital costs. He was, moreover, aware that the princi- 
pal executives involved were of the opinion that the system provided adequate 
control. He himself felt it to be a valuable management tool in relation to the 
time it required and did not envisage any major changes. 

Does the shop order Committee exercise effective control? If so, in 
what way? 

What changes, if any, would you recommend in the company's 
system of control over repair costs and capital expenditures? 



ease 



11 



STRATFORD FOODS, INCORPORATED (II) 

Establishing a Program of Internal Audit 

This case is primarily descriptive of the organization and operation 
of an internal audit department in a large company. This case can 
be used in sequence with Richland Foods and Northern Alliance, 
all dealing with internal audit of Stratford Foods and subsidiaries. 

Stratford Foods was a large producer and distributor of nationally 
advertised food products. Sales for 1949 were over $300,000,000; 
assets topped $100,000,000. Stratford had plants in ten states and 
sales offices in important cities all over the world. The company was 
organized on a divisional basis with line responsibility residing in 
division heads. Coordination of the functional activities (manufac- 
turing, sales, finance, etc. ) was the responsibility of staff men at the 
home office in New York City. 

Internal Auditing 

The internal auditing department was responsible directly to the 
controller and, indirectly, to the audit committee of the board of 
directors. The department, which had been created by order of the 
board, served as the "eyes and ears" of top management. The cost 
of operating the department was approximately $100,000 per year. 
Mr. Albert Sauer, head of the department, had a staff consisting of 
an assistant and four senior, four semi-senior, and eight junior 
accountants. : 

Audit Procedure 

The procedure followed by the auditing department in making an 
internal audit was in many respects similar to that employed in inde- 
pendent audits, except that the internal audit was often broader in 
scope. 

The first step in the audit program was the preparation of a sched- 
ule of plant locations to be audited. The board, when establishing 

100 



STRATFORD FOODS, INCORPORATED (II) 101 

the internal audit department, set down two rules to guide tlie de- 
partment in this phase: 

a) Raw material storage audits were to be made each year. 

b) Manufacturing and other audits were to be made once every 
fifteen months. 

These internal audits were, of course, in addition to the regular 
audits performed by Stratford's independent public auditors. They 
were generally conducted on a surprise basis and in conformity with 
a pre-established audit program. 

Each audit was in the charge of a senior accountant who had as- 
signed to him a team of two to five men depending on the size of the 
job to be done. Audits were made by function rather than by divi- 
sion. The four functional audit programs were: 

1. Traffic 

2. Raw Materials Storage 

3. Plant and Sales 

4. Special Service 

Since Stratford consisted of eighteen semi-autonomous divisional 
units, each of which was quite large, it was not considered feasible 
for an internal audit to cover a whole division. Instead, geographical 
location comprised the basis for audits. For example, there was a 
processing plant, a sales office, and a storage warehouse in St. Louis, 
all of which were part of the "mid-central" geographical area, and 
would, therefore, be included in the same internal audit. 

Although a general audit program is prepared for each of the four 
functional areas mentioned above, the senior auditor in charge on 
the job is expected to use his own judgment in adopting the general 
audit program to any given audit situation. 

During the auditing team's visits to the various plants, factual 
materials relating to the internal audit system were collected. Opin- 
ions expressed by the auditors were usually limited to those that 
could be documented with such factual materials. 

Upon completion of the audit, the senior auditor prepared a manu- 
script of his findings, including material relative to the scope of the 
audit and the degree to which the audited units had adhered to the 
company's policies. This report contained all the pertinent facts, 
and was supported by detailed audit work papers. 



102 INTERNAL CONTROL AND INTERNAL AUDIT 

The audit report was then discussed with the operating manage- 
ment and controller of the division being audited in order that the 
views of those parties might be incorporated in the report. (Mr. 
Sauer, head of the company's Internal Auditing Department, made 
it a point to be present for the review at some of the more important 
audit locations.) Although the report was intended to present the 
audit findings in as factual a manner as possible, it did include com- 
ments on areas in which, in the auditors' opinions, the plant audited 
had either fallen below the prescribed standards and needed cor- 
rection, or, at the other extreme, had done an outstanding job. In 
case the division controller and the auditor failed to agree on a par- 
ticular point, the matter of controversy was included in the audit 
report along with the opposing points of view and the auditors' 
recommendations. 

The report was then presented to Mr. Sauer at the home office, 
who reviewed the working papers and audit report, assured himself 
that they were in order, and consulted functional heads in the home 
office when such action seemed warranted. The final report issued, 
therefore, contained all the pertinent facts as well as opposing points 
of view on action indicated. 

Finally two reports were prepared based upon the audit report 
and the discussions. The first report was a summary of the final re- 
port and highlighted the auditor's findings at the plant visited. The 
second report was a detailed supporting document. 

The summarized report, which was issued within fourteen days 
of completion of the audit, was presented to the president, chairman 
of the board, and other interested members of the central executive 
staff. The detailed reports were sent to interested department heads 
in the New York office, and to the division controller; detailed re- 
ports were usually issued within six weeks of the completion of the 
audit. 

The reports for the division controller were routed through the 
methods department. A letter of transmittal to the division bearing 
the signature of Mr. Martin Breen, head of the methods department, 
was prepared by him in conjunction with the auditing department. 
This letter commented upon any unusual aspects of the audit and 
was really the first step in the audit follow-up procedure. If any 
glaring needs for correction were disclosed in the audit report which 
demanded the attention of some functional executive, these errors 



STRATFORD FOODS, INCORPORATED (II) 103 

were then discussed jointly by the New York department head and 
the auditing department. These two departments cooperated in pre- 
paring a letter to the person responsible in order to facilitate follow- 
ups. The division controller was expected to initiate action, to correct 
any faults described in the audit report, and report back to the cen- 
tral office as to how successful he had been in correcting the weak- 
ness disclosed by the audit report. 

In commenting on the role of the internal auditing department, 
Mr. Sauer, the department head, commented as follows. 

The auditing department never acts upon its findings on its own. The 
methods department is responsible for follow-ups, although the auditing depart- 
ment is kept informed of all developments. It has authority to question the 
follow-up pertaining to specilic points when it is not satisfied, and actually 
maintains the follow-up correspondence files (for the benefit of subsequent 
auditors). The reason the auditing department does not participate directly in 
the audit follow-up is that to do so would place it in a position of being both 
patrolman and judge. The rules to be followed are set up by the methods depart- 
ment in standard procedure manuals. (The auditing department, and others, 
are consulted concerning new procedures, and although the auditing department 
thus gives tacit approval of such procedures before they are made effective, it 
reserves the right to change opinions after seeing the procedures in action.) 
The auditing department merely audits to assure itself and the company that 
these rules are being followed or, on the other hand, that the rules are unwork- 
able or otherwise not proper and merit modification. 

The company's audit follow-up procedure was highly flexible. 
When a point came under discussion, the particular circumstances 
surrounding the case were carefully weighed. The methods depart- 
ment was always prepared to change its procedures if it found they 
did not fit the circumstances. 

Copies of the internal audit reports were also made available to 
the company's public auditors. Although outside auditors had noth- 
ing to do with the framing and performing of the internal audit, they 
did provide an independent check on the scope, accuracy, and ac- 
complishments of the internal audit department. 

(The internal audit department reported to the board of directors 
once each year describing its work during the year, and presenting 
in summary form its findings and comments. 

: Purpose of the Internal Audit 

The purpose or function of the internal audit department was 
j! briefly mentioned in an earlier section of this case. The ruling set 



104 INTERNAL CONTROL AND INTERNAL AUDIT 

down by the board of directors called upon the internal audit de- 
partment to check directly the adequacy of the system of internal 
control. Specifically, the board required that ". . . the audit program 
be designed to ascertain that the assets are being conserved and 
protected, that approved procedures are being followed, and that 
adequate internal checks are being applied. The application of the 
audit program should provide that accounting procedures at the 
offices audited are generally in order and that their performance is 
fundamentally accurate. The investigation of the adequacy of in- 
ternal control should include ( 1 ) a determination that the system of 
internal control is adequate and will minimize errors and defalca- 
tions, and (2) suitable test-checks be made to determine that the 
system is being maintained. In the presentation of audit findings 
the audit department should differentiate insofar as possible be- 
tween errors in performance (judgment) and deficiencies in the 
accounting system, and the relationship of the two." 

The scope of Stratford's internal audit was much greater than that 
of the audit regularly performed by the company's independent 
auditors. The internal audit report included notes on personnel, on 
sales, manufacturing, and finance, and on organizational problems. 
Emphasis was placed on internal control and adherence to company- 
wide policies. The reports themselves, although written for those 
who were already fairly familiar with the company's accounting 
procedures, were presented in as generally meaningful a form as 
possible; percentages were freely used, and comparative data were 
provided, as among various divisions as well as for different years. 

The purpose of the auditing department was not considered to be 
uncovering illicit acts. It was more or less assumed that all depart- 
ments would attempt to follow the policies as described in the pro- 
cedures manuals, and that any deviations were made for legitimate 
purposes, or due to natural inadvertency. Audit programs were writ- 
ten by Mr. Sauer and were based upon general company policies as 
described in the procedures manuals and upon generally accepted 
accounting principles. 

How should the top management of Stratford go about deciding 
how much to spend for internal auditing? 



ease 



12 



RICHLAND CORPORATION 

Follow-up of an Internal Audit 

This case deals with the purposes and objectives of procedures used 
by a parent company in following up the submission of an internal 
audit report on a subsidiary corporation. 

The Richland Corporation, a division (wholly owned subsidiary) 
of Stratford Foods, Inc., produced and sold food products through- 
out eastern Canada. In line with the parent company's policies, an 
internal audit was performed for this division as of November 30, 
1945; the next such audit was made at September 30, 1947. The first 
audit included the years 1943, 1944, and 1945; the second covered 
the years 1946 and 1947. War pressures had precluded more fre- 
quent audits during this period. The pertinent rulings in the com- 
pany's procedures manuals, and the audit programs relating to the 
accounts examined and reported in the audits referred to above, are 
presented in Exhibit 1. 

The reports of these two audits, which are reproduced below, are 
restricted to certain substandard phases of operations. The follow-up 
work which was accomplished between the two audits is described 
immediately following the report dated January 28, 1946. Both re- 
ports deal with the food packaging plant located in London, Ontario. 
These audit reports were sent to both the Richland and Stratford 
chief executives. Reports such as these, generally referred to as 
"short" reports, were used by Stratford's chief executives as a means 
of maintaining contact with its various subsidiaries and divisions as 
well as a routine review of the accounting operations. Typically, 
action was taken by the Stratford management as a result of such 
audit reports only in cases where items of material consequence 
were disclosed. 

A full "long" report was always, as a matter of policy, submitted 
to the controller of the division concerned. It was his responsibility 
to supervise the accounting staff of the audited plant in initiating 
any corrective action indicated by the audit report. 

105 



106 INTERNAL CONTROL AND INTERNAL AUDIT 

The audits included investigation of all "significant factors" in the 
plants operations. Those areas not mentioned in the reports which 
follow were, in these cases, considered satisfactory and consequently 
received a minimum of attention from the auditors and management. 

An organization chart for Stratford Foods, Inc., is reproduced in 
Exhibit 2. 

AUDIT REPORT OF THE LONDON, 
ONTARIO, PACKAGING PLANT 

November SO, 1945 

From: Auditing Department January 28, 1946 

Stratford Foods, Inc. 
New York, New York 

Gentlemen : 

The following report presents the results of an audit of the mill 
and sales operations of the London, Ontario, office of the Richland 
Division of Stratford Foods, Inc., for the period from February 28, 
1943, to November 30, 1945. 

Scope of Audit 

The mill stocks of finished products and ingredients at London 
and the stocks at the branch warehouse in Hamilton were counted, 
and test-counts were made of the mill stocks of empty packages. The 
wage payroll checks for one pay period were distributed, the em- 
ployees being identified insofar as possible. Test-checks and exami- 
nations were conducted of the records kept and the operations 
performed during the audit period, and the financial statement ac- 
counts on which the primary or subsidiary records were kept at 
London were analyzed and investigated as of November 30, 1945, 
the balances being checked by correspondence to the general ledger 
records maintained by the divisional office. 

Traffic operations were reviewed brieflv. No review was made of 
purchasing operations and accounts. 

The results of the audit were reviewed in detail with the local 
management. 



RICHLAND CORPORATION 107 

Changes in Personnel and Organization 

Effective July 1, 1945, Mr. A. L. Smith, formerly a member of the 
accounting staff at San Francisco, was transferred to London as 
office manager, replacing Mr. A. M. Peters, who was appointed chief 
accountant for the West Division. In January, 1944, Mr. L. M. Untea, 
formerly of the accounting staff at San Francisco, replaced Mr. Smith 
as office manager, the latter being transferred to a similar position at 
Portland. 

Mr. M. P. Cogan, formerly plant superintendent of the Franconia 
soup plant, was assigned the newly created position of assistant 
plant superintendent at London on April 1, 1944. 

Mr. R. A. Brant was transferred from the London accounting de- 
partment on January 18, 1945, to the branch warehouse at Hamilton 
as office manager, replacing Mr. B. Q. Furst, who left the company. 

On approximately June 15, 1945, Mr. S. Abrams, formerly a mem- 
ber of the London accounting staff, was appointed to the position of 
London office assistant for the coffee sales manager. 

Upon his return from military service in April, 1945, Mr. H. A. 
Prince replaced Mr. Golden as personnel supervisor, the latter being 
transferred to Spokane as milling superintendent. 

Effective September 24, 1945, Mr. F. T. Axlerod, former elevator 
foreman, was appointed elevator superintendent, replacing Mr. P. K. 
Rogers, who terminated his employment with the company. 

Delivery and Production Statistics 

Comparative production statistics for the London mill and de- 
livery statistics for the London-Hamilton grocery products activity 
for the eleven months ended November 30, 1944, and November 30, 
1945, and for the fiscal years ended July 31, 1944, and July 31, 1945, 
are presented on page 108. 

General Condition of OfTice 

Although some of the accounting continued to be handled in a 
generally satisfactory manner and certain of the exceptions pre- 
viously reported had been effectively eliminated, some previously 
reported weaknesses were still in evidence and new exceptions in 
rather important phases of the accounting were disclosed to indicate 
a poor over-all performance. Exceptions noted in those phases of the 



108 



INTERNAL CONTROL AND INTERNAL AUDIT 



work dealing with mill stocks and mill payroll indicated that in- 
creased supervision of certain accounting details would be desirable, 
and the need for securing more accurate and complete original pro- 
duction data was indicated by the noted errors and omissions in 
the reports of such information and by the over-all accounting re- 
sults reported for mill stocks. 

Remedial action was taken during the audit to eliminate several 
of the weaknesses noted, and in other instances measures were being 
considered to effect the needed improvements at the completion of 
the audit. 





Eleven Months Ended 


Increase or 


,-' . _ ' ■ 1 


Nov. 30, 1945 


Nov. 30, 1944 


( — ) Decrease 


Production-London : 

Vegetables (lbs.) 
Fruits (lbs.) 
Other Canned Goods ( lbs. ) 

Deliveries— London & Hamilton: 
Coffee ( lbs. ) 
Package Foods (lbs.) 


2,300,000 
746,100 
742,000 

92,000 
240,000 


2,360,000 

857,500 

1,087,900 

99,000 
270,000 


- 60,300 
-111,400 
-345,900 

-7,000 

- 30,000 





Fiscal Year Ended 


Increase or 


.- • 


Jul. 31, 1945 


Jul. 31, 1944 


( — ) Decrease 


Production— London : 

Vegetables ( lbs. ) 
Fruits ( lbs. ) 
Other Canned Goods ( lbs. ) 

Deliveries— London & Hamilton: 
Coffee (lbs.) 
Package Foods (lbs.) 


3,000,000 
1,078,000 
1,344,200 

120,500 
350,000 


2,500,000 

906,500 

1,059,000 

121,200 
320,000 


500,000 
171,500 
285,200 

-700 
30,000 



Principal Points and Those Requiring Improvement 

7. Plant Payroll (Packaging) 

Fifty-live inaccuracies were disclosed in the auditors' check of the 
plant payroll for two weekly periods, twentv-eight in the computa- 
tions for the week ending November 18 and twentv-seven for that 
ending November 25, 1945. Included were twelve errors in comput- 
ing shift differentials, eight inaccuracies in computing half-time 
rates, ten errors in computing hoiu's worked, thirteen errors from 



RICHLAND CORPORATION 109 

using obsolete wage rates, four errors from using faulty wage rates, 
and eight miscellaneous inaccuracies. In addition, subsequent fol- 
low-up to determine whether the above inaccuracies had been cor- 
rected disclosed six instances in which additional errors had been 
made in effecting the corrections. 

The independent check of payroll factors was not sufficiently com- 
plete in that the check of the payroll clerk's work included only a 
verification of basic wage rates (from the clerk's rate books, which 
was often not in a current condition). However, what with basic 
rates and one or more special job rates possible, two possible shift 
differential rates applying to each, and each hourly rate possibly 
calling for a half-time rate to cover overtime hours, money amounts 
on time cards often represented the aggregate of five or six (or 
more) combinations of hours times rates. Of such combinations, the 
accuracy of none of the hours and of only basic rates was proved by 
the existing independent check. 

Periodic independent distributions of payroll checks by an admin- 
istrative employee, as required by the Manual of Personnel Proce- 
dure, were not being made. 

The auditors were assured that the necessary remedial measures 
would be taken to improve the original accuracy of payroll work 
and to broaden the scope of the independent check of payroll fac- 
tors. Periodic administrative distributions of payroll checks were to 
be resumed. 

2. Mill Stocks 

Individual and net differences disclosed by the auditors' count 
and those experienced in prior months were unduly large. 

Deficiencies in the reporting of daily production activity were, in 
some instances, proved to have resulted in inaccurate production 
data; included in such deficiencies were (1) the failure to register 
certain production, particularly of large sizes, (2) improperly in- 
dicating register readings— by showing opening and closing readings 
for entire shifts, etc., rather than for each brand and size— for cer- 
tain production, (3) violating manual-prescribed procedures for 
handling sacks broken in packing, (4) having packing foremen 
prepare packers' tallies (to some extent from daily packing orders 
rather than from actual register readings) and fed-in reports rather 
than requiring they be prepared by the packer or feed-in man per- 



no INTERNAL CONTROL AND INTERNAL AUDIT 

forming the operation, and (5) employing, to some extent, a prac- 
tice of adding to or altering original production reports ( principally 
fed-in reports) to obviate stock differences being experienced. 

Gross inadequacies in the count-and-investigate procedures were 
apparent, stemming largely from a lack of cooperation between the 
manufacturing department and administrative departments, prin- 
cipally as represented by the stock counter and stock ledger clerk, 
respectively. A lack of personal contact between these employees- 
one of the lesser weaknesses arising from the counter's being a 
manufacturing department employee— contributed to this lack of 
cooperation. Extremely large count differences were often not sought 
through recounts, principally due to the general lateness in making 
the original count comparisons available to the stock counter. Be- 
cause some confusion appeared to exist as to whose was the respon- 
sibility for investigating count differences, the resulting measure of 
investigation was entirely too meager to be considered effective. 
Extremely large adjustments resulted. 

Two manufacturing adjustments were noted to have been pre- 
pared by the stock counter in his capacity as an operating employee; 
one of these corrected for a fictitious fed-in report admittedly pre- 
pared by the stock counter to eliminate a count difference. One other 
manufacturing adjustment was noted to have been altered to cover 
an existing count shortage. 

Considerable improvement would be necessary to raise the level 
of accounting for mill stocks to a satisfactory level. Proposed reme- 
dial measures were outlined in connection with the audit review, 
however, and assurances given that such measures would be adopted 
as rapidly as conditions permitted. 

As of November 30, 1945, the number of unfilled orders was large 
but no difficulty was anticipated in effecting delivery of all contracts. 

The auditors wish to express their appreciation of the cooperation 
and courtesies extended them by the personnel of the London and 
San Francisco offices during the audit. 

Respectfully submitted, 

A. B. Norman 
F. M. Shelby 

J. B. CORMACK 



RICHLAND CORPORATION 111 

DETAILED AUDIT REPORT 

1. Plant Payroll 

Principal Weaknesses or Exceptions 

Twenty-eight and twenty-seven inaccuracies, respectively, were 
disclosed in the auditors' review of the payrolls of November 18 and 
November 25, 1945. Efforts to correct these inaccuracies resulted in 
six additional errors. 

The independent check of payroll factors was incomplete, in that 
many of the hour and rate factors used in the actual computations 
were not covered, and ineffective, in that some noted inaccuracies 
had been missed. 

Delays in posting changes to the rate records book resulted in 
numerous mispayments. 

Remarks 

Periodic, independent distributions of payroll checks by an admin- 
istrative employee, as required by provisions of the Manual of Per- 
sonnel Procedure, were not being made. 

2. Mill Stocks 

Principal Weaknesses or Exceptions 

Differences disclosed by the auditors' count and those experienced 
in prior months were unduly large. 

Deficiencies in the reporting of daily production activity— includ- 
ing failure to register certain production, employing improper 
methods in preparing packers' and fed-in tallies, and making some 
unauthorized alterations in original production reports— coupled 
with gross inadequacies in the count-and-investigate procedures, 
and with weaknesses attending the counter's being an operating 
employee, contributed to a decidedly unsatisfactory condition dis- 
closed by the audit and, materially, to the size of the differences 
being experienced. 

Remarks 

Some of the adverse disclosures of the audit appeared to have 
stemmed from a lack of cooperation between the manufacturing and 



112 INTERNAL CONTROL AND INTERNAL AUDIT 

administrative departments, particularly as represented by the stock 
counter and stock ledger clerk. Some of the violations noted had 
been reported in previous audits. 

Detailed Comments 

Mill Stocks 

A decidedly unsatisfactory condition in the control over mill 
stocks, involving deficiencies in the reporting of daily stock activity, 
coupled with an ineffectiveness in the count-and-investigate proce- 
dures, was disclosed by the auditors' review. 

Some of the auditors' exceptions represented basic violations of 
standard stock control procedures; some had been reported before 
in connection with previous audits. The exceptions noted are pre- 
sented in more detail in the following topical paragraphs: 

Results of Auditors' Count 

Both the individual differences by brand and size and the net 
difference necessary to adjust book balances to agree with the audi- 
tors' count (as of November 30, 1945) were large. Included as in- 
dividual differences, for example, were shortages of 371— 25's and 
350-5's of linseed oil, 103-10's and 70-5's of olive oil, 27-100's of 
Mix K, 18-100's of Mix L, 23-100's of unital, and 44-100's of Mix 
M, and overages of 98-25's of ohve oil, 186-25's of Grade C, 18- 
100's of canned peas, and 31— lOO's of Mix F. In total, the auditors' 
count disclosed a net shortage of 207 pounds of oils and a net over- 
age of 23 pounds of vegetables. 

Extent of Previous Adjustments 

Previous individual monthly adjustments by brand and size were 
large, including, for example, such differences as those presented 
in the tabulation on page 113. 

In general, the size and extent of the differences being experienced 
appeared to be abnormally high in relation to the size of the mill 
and these differences evidenced weakness in the control over the 
mill stocks. 



RICHLAND CORPORATION 



113 



Brand 


Size 


Quantity 


Date 


Oils 


5 


-1,130 


March, 1945 


Oils 


25 


-382 


January, 1945 
July, 1945 
May, 1945 


Oils 


10 


-420 


Grade C 


25 


500 


Olive Oils 


25 


-162 


January, 1945 


Olive Oils 


25 


-116 


October, 1945 


Mix G 


100 


-59 


August, 1945 


Marva 


100 


63 


March, 1945 


Mespa 


100 


-42 


June, 1945 
February, 1945 


Canned Beets 


100 


71 


CoflFee 


100 


100 


April, 1945 


Tea 


100 


52 


April, 1945 





Deficiencies in Recording Production of One and Three Pound Sizes of Coffee 

The production facilities at the London mill provided for the 
packout of I's and 3's on both the third and first floors of the mill. 
Third-floor facilities included a pneumatic packer, interchangeable 
between the two sizes, coupled with a tape sealer and a case and/or 
bale sealer. All tape sealed bags of these sizes were packed out 
through this equipment. First-floor equipment included two con- 
ventional packers for the production of 3's (or larger) tie-type bags. 
Production of 3's on this floor was seldom baled or cased, and, if so, 
it was strictly a manual operation. 

The pneumatic packer on the third floor was equipped with one 
register (sometimes a second register was provided, it was stated) 
which was used as an order register, and the coupled case and/or 
bale sealer was equipped with both a cumulative and an order reg- 
ister. Under this arrangement, no cumulative packing register read- 
ings were available to support production of loose I's and 3's ( quan- 
tities reported were stated to have been obtained from the one or 
two order registers on the packer) or to serve as a check of pro- 
duction tallied by the case and/or bale sealer. In addition, packing 
tallies covering cased or baled production sometimes indicated only 
opening and closing cumulative sealer register readings, despite 
more than one brand having been packed off during the run. The 
auditors' recommendations for obviating the deficiencies in record- 
ing the third-floor pack-out of these sizes included ( 1 ) the providing 
of a cumulative packing register for supporting the production of 
loose I's and 3's and for checking the production of baled or cased 



114 INTERNAL CONTROL AND INTERNAL AUDIT 

pack-out and (2) the indicating of cumulative register readings on 
tallies for each brand and size. 

When the two conventional packers on the first floor, used for 
packing tie-type 3's (and larger), were examined by the auditors, 
each was noted to be equipped with two registers; however, onlv 
one register was attached on one packer, and neither register was 
attached to the other. Although the plant superintendent believed 
that no packer would ever be operated without at least one register 
being operative, it appeared that cumulative registers were never- 
theless not employed since reported production of tie-type bags 
was customarily not supported by tallied register readings. The 
auditors recommended that cumulative registers be provided and 
the readings thereof be required to support production of tie-type 3's. 

Follow-up to the Audit of November 30, 1945 

The follow-up to the November 1945 audit report, which described 
a generally unsatisfactory condition, started with the chief plant ac- 
countant at London writing to Richland's controller in Toronto. The 
chief accountant had been called upon to explain the existence of 
the conditions uncovered by the report. In a letter dated March 3, 
1946, the chief accountant stated: 

1. Plant Payroll— Plant 

At London, Manufacturing Department employees prepare the plant pay- 
roll. This harks back to the days when manufacturing was a separate "divi- 
sion," and the arrangement has survived several audits. Audit criticism 
cannot be pointed at the administrative office for this operation. It should 
be noted that a "good" rating was given to the "Mill Payroll," an operation 
performed in the administrative office. 

Inability to take trained personnel away from essential duties was the chief 
reason independent payroll check distribution was not made by the office. 

2. Mill Stocks 

Five listed criticisms were of functions or practices of the manufacturing 
department and represented, in part, procedures allowed in previous audits 
because of local conditions. Irregularities, when called to manufacturing 
department's attention, were not given cooperative treatment, and improve- 
ment was not effected. Lateness in returning original count comparisons was 
almost entirely proportional to lateness in receiving counts from the manu- 
facturing department. General explanation for lack of re-counts was that 
the stock counter was needed elsewhere in the plant. No manufacturing 
adjustments were issued to adjust stock counts with my approval or with 



RICHLAND CORPORATION 115 

adequate, legitimate explanation. Administrative awareness of a poor con- 
dition here is best indicated by the fact that I spoke to you of it a number 
of times and also called the attention of the auditing department to our 
diflBculties. 

On May 28, 1946, the controller of Stratford Foods, Inc., sent the 
following comments to the controller of the Richland division. 
Speaking of the unsatisfactory condition of the London plant, he 
said: 

It is apparent from the report and from the letters we have seen to date 
relative to this audit that a number of factors contributed to this condition, the 
principal ones being high personnel turnover in recent years, somewhat in- 
effective distribution of the work between the administrative and manufactur- 
ing departments, absence of full cooperation between departments, and, behind 
all of this, a not too satisfactory physical layout to encourage the highest degree 
of efficiency. 

Organization 

Up until the time that Mr. Jones was made office manager at London on 
June 15, 1945, it had been our impression that there had been something lack- 
ing in the cooperation between the administrative office and the two plants, 
evidenced principally by the resistance of the plant superintendents to sugges- 
tions relating to accounting matters and some lack of confidence in their think- 
ing as to the accuracy of the office records. The former setup whereby the plant 
operations reported to New York further complicated this arrangement. The 
tendency of each to "build a fence around" its operations was not particularly 
healthful, and during this period some of the clerical work ordinarily performed 
in the administrative office was taken over by the manufacturing department, 
although in our opinion it doesn't really belong there. We have reference to 
plant payroll, empty package records, and stock counting. 

The appointment of an over-all plant manager at London makes a realign- 
ment of responsibilities along correct lines workable. This should be the logical 
time to get the foundation properly laid so that the accounting and clerical 
work will be under the administration of the office manager, where it can best 
be administered. Until this is done, we believe that there will be continuing 
difficulties. 

General 

In prior years it has been mentioned that the manufacturing department 
personnel at the plant did not have complete confidence in the records main- 
tained in the administrative office. Until such confidence is restored, there will 
always be some feeling of doubt on the part of the people in the plant and 
hesitancy on their part to relinquish accounting functions which they now 
perform. Special stress in this regard should be directed to the office manager 
in your follow-up so that the office manager can better appreciate his respon- 
sibilities in regard to record keeping and the maintenance of adequate internal 
control and at the same time furnishing the necessary operating data to the 
manufacturing department people. 



116 INTERNAL CONTROL AND INTERNAL AUDIT 

From an accounting point of view it appears that the following steps should 
be given serious consideration in connection with the primary constructive work 
in improving the condition reported by the audit. 

1. Transfer the responsibility for the plant payroll computation from the 
plant personnel to the administrative office. 

2. Assign the stock counting responsibilities in the mill to an administrative 
office employee. 

3. Clarify between the stock counter and the stock ledger clerk the responsi- 
bilities for investigating stock differences. 

4. Transfer the responsibility for the maintaining of sack ledgers from the 
mill office to the mill administrative office. 

The chief executive of the Richland division was disturbed by the 
unfavorable report. Consequently, he requested all his subordinates 
who were in any way responsible for the unsatisfactory conditions 
to provide a written explanation of why such conditions existed. The 
office manager of the London plant forwarded the following state- 
ment: 

After considerable discussion it was agreed that the seriousness of the matter 
requires immediate corrective measures requiring the full cooperation of every- 
one having any responsibilities for our accounting controls. In connection with 
payroll errors, it was brought out that the ten minute leeway in punching time 
cards had caused no little difficulty in reading the punches on the cards as it has 
increased the number of instances where one time is punched over another. 
This is particularly true at midnight when the clock jumps from the p.m. to the 
A.M. markings. Several suggestions were made to help improve this situation 
but it was decided that this should be held over in order to give further 
thought to the problem. 

The head of the Stratford auditing department, upon review of 
the files on the audit and follow-up, wrote the following memoran- 
dum to the head of the Richland division: "Follow-up does not ap- 
pear to be complete, but we are closing the files now in view of . . . 
[another] soon-to-be audit." The report on the forthcoming audit to 
which the auditing department head refers follows. It also deals with 
the points on which criticism had been directed in the previous 
audit. 

From the Audit Report of the London, Ontario, 
Packaging Plant— September 30, 1947: 

Mill Stocks 

The mill stocks had been accounted for in a generally satisfactorv manner, 
reflecting a marked improvement over the substandard performance reported 
during the previous audit. Although the stock adjustments reported in the 



RICHLAND CORPORATION 117 

earlier months of the audit period— in particular, before April, 1947, when the 
packing of large sizes was discontinued— and the net coffee shortage of 515 
pounds, experienced during the fiscal year ended July 31, 1947, appeared some- 
what large, a favorable trend of performance in the form of reduced stock ad- 
justments was evident for both coffee and other stocks. 

Investigations of the differences disclosed by the auditors' counts (most of 
these differences were generally reasonable) disclosed a few obvious errors by 
mill employees in reporting production, fed-ins, and loadings in the less active 
stock items, suggestions that the larger differences being experienced in the 
more active items were being caused by similar inaccuracies. 

Most of the procedural weaknesses previously noted had been corrected 
during the audit period, but violations of certain manual requirements were 
still evident in the practices of (1) having fed-in reports prepared by shift 
foremen rather than the men performing that operation, (2) failing to show 
on packers' tallies bags that had been broken in packing, and (3) hand-tripping 
registers to record as production the full sacks that were recovered from 
spillage or from contents of sacks that were broken before the registers had 
tripped. 

From the Detailed Audit Report: 
Mill Stocks 

Principal Weaknesses or Exceptions * 

Although the differences disclosed by the auditors' count were generally 
reasonable, adjustments made to floor counts in certain previous months and 
the net coffee shortage (515 lbs.) experienced during the fiscal year ended 
July 31, 1947, appeared somewhat large (Schedule III) . 

Contrary to the Manual of Stock Control Procedures, packing registers were 
on occasion hand-tripped to record certain production, and fed-in reports were 
prepared by shift foremen rather than by the employee performing the feeding- 
in operation. 

Remarks 

The large adjustments reported during the audit period were noted to have 
been concentrated in a few scattered months, and it was stated that dilBculties 
occasioned by faulty register operation (February, 1947) and inexperienced 
stock counters (February and May, 1947) contributed to the differences then 
experienced. 

Of the twelve manufacturing adjustments issued during the eight months 
ended August 31, 1947, one lacked an adequate explanation, seven had not 
been properly approved, and one appeared to have been prepared without suf- 
ficient proof of error. 

Plant Payroll 

Principal Weaknesses or Exceptions 

Five errors in applying wage rates (resulting in a net overpayment of $3.16), 
were disclosed during the auditors' review of the payroll for August 10, 1947. 



118 INTERNAL CONTROL AND INTERNAL AUDIT 

Periodic independent distributions of payroll checks by administrative em- 
ployees had not been made durng the nine months from November 14, 1946, to 
August 18, 1947 (the date of the auditors' arrival). 

Remarks 

Miscellaneous exceptions disclosed by the auditors' examination of time cards 
included two instances in which check-out times were lacking, three cards on 
which wage rates did not bear the foreman's approval, and three instances of 
late check-outs. 

Except for the exceptions noted, payroll operations seemed generally satis- 
factory, and represented an improvement over a previously reported unsatis- 
factory condition. 

Mill Stocks 

Considerable improvement over the decidedly unsatisfactory condition in the 
control over mill stocks reported at the time of the previous audit was disclosed 
by the auditors' review. In general, most of the previously reported procedural 
weaknesses had been either satisfactorily corrected or evidenced definite im- 
provement, indicating that, on the whole, follow-up had been satisfactory. 
Although adjustments made to floor counts in certain previous months and the 
net cumulative coffee shortage (515 lbs.) experienced during the fiscal year 
ended July 31, 1947, were larger than could be considered entirely reasonable 
(indicating that the seemingly adequate stock control program in effect had 
not functioned in a completely satisfactory manner at all times ) , the individual 
and cumulative differences for 1946-47 bettered those for 1945-46, and those 
for the three months of the current fiscal year bettered those for 1946-47. 
The improved trend appeared evident for both coffee and other stocks. Differ- 
ences disclosed by the auditors' count as of September 30, 1947, were generally 
reasonable. 

A factor which undoubtedly contributed to the improved stock performance 
in the more recent months of the audit period was the discontinuing of large 
sizes March, 1947. An appreciable portion of the previously reported exceptions 
concerning deficiencies in reporting production pertained to I's, 3's, and 5's; 
although these deficiencies may have been corrected prior to the conversion to 
restaurant sizes exclusively, that fact could not be definitely ascertained by 
the auditors. It could not be determined at the time of the audit whether the 
pack-out of large sizes would be resumed at London, but it is suggested that 
in the event that this operation is resumed, a generous measure of attention be 
given it, lest the favorable trend in stock performance be interrupted. 

Production Reporting 

In general, prescribed procedures (as they applied to restaurant sizes) had 
been put into effect during the audit period; duplicate registers were used on all 
packing machines, and a check on the accuracy of the packers' tallies (together 
with a check of the carrying forward of register readings) was begun in the 
administrative office. One deficiency still existed, however, in that sacks broken 
in packing, the contents of which were lost in sweepings or emptied in the 
packers' weigh boxes, were not shown on the tallies for use in computing net 
production. Further, in violation of manual procedures, registers were hand- 



RICHLAND CORPORATION 119 

tripped to record production of full sacks recovered from spillage or from con- 
tents of sacks broken before registers had tripped. 

It was stated that, in the future, broken sacks lost in sweepings would be 
indicated on the packers' tallies, and that unregistered production would be 
separately indicated on the tallies rather than recorded by hand-tripping 
registers. 

What follow-up procedures would you recommend to the heads of 
the auditing and methods departments? 

EXHIBIT I 

Stratford Foods, Incorporated 

A. Taken from the Mill and Sales Audit Program and Procedure Questionnaire 
of the Auditing Department of Stratford Foods, Inc., used by the field 
auditors in conducting an audit. 

I. Payroll Audit of a Mill 

1. Distribute all checks on first payroll after arrival and obtain signa- 
tures of employees for checks issued. Identify employees by com- 
paring signatures with those in personnel department files with 
those in personnel department files for authenticity. 

Period covered by payroll distributed: 
a. Compare names secured with those on preceding payroll and 
account for all additions and deductions. 

2. Check payrolls as follows: 

a. On last payroll before arrival, check hours, rates, extensions 
and deductions for the entire payroll (or for about 300 
scattered employees at larger plants ) . 

Period covered: 

Record from which hours were checked: 

Record from which rates were checked: 

b. Check authorizations of employment and rates for proper ap- 
provals and completeness of records. 

c. Check parts of additional payrolls if conditions shown by 
audit of last payroll were poor. 

d. Check totals on three payrolls to vouchers on operating account 
or to Accrued Payroll Account. 

e. Determine that overtime payments are controlled. 

f. If week selected does not include payments for suggestion 
awards, audit a few such payments for another week. 

II. Cash Disbursement Audit 

1. Examine vouchers for all details for at least one month and every 
third voucher for two scattered half months. 

Period audited 

Voucher reference 

Number of vouchers audited 

2. Check vouchers for the full month audited to cash disbursements 
journal. 



120 INTERNAL CONTROL AND INTERNAL AUDIT 

3. Simultaneously with audit of vouchers for the last month before 
the audit, watch for omissions of unpaid bills set up at the pre- 
ceding closing, and also check approximate accuracy of the 
liability on those bills which were set up. ( Discuss in report under 
heading of unpaid bills.) 

III. Mill and Plant Stocks Audit 

1. Count all stock in packages, including the ingredients and con- 
centrates on which records are kept in packages. Measure bulk 

- stocks, including coffee (if any) and including all ingredients, if 

such stocks are considered mill inventory, 

2. Reconcile count with stock records and trace all unreasonable 
differences; recount items on which large differences cannot be 
explained. Reconcile measurements with control records and in- 
vestigate unreasonable differences. 

3. Reconcile by commodity classifications, the quantities per the con- 
trol records as of the date of the auditor's count and/or meas- 
urement to ending inventories reported on the most recent operat- 
ing stock statement. 

4. Examine individual stock and manufacturing adjustments for the 
past six months. 

a. Include in this examination a review of the stock adjustments 
for all ingredients and a review of fed-in stock. 

b. Prepare for the work papers a schedule of the net monthly 
stock variations (per Operating Stock Statements) experienced 
during the audit period; include data in report if quantities 
appear unreasonable. 

5. Check the blending variation report for one month in detail. Re- 
view the variations for at least six months and investigate the 
large ones. 

6. Review method of taking the reporting bin inventories. 

7. Check all stock ledger data from original sources (packers' tallies, 
invoices, etc. ) for a period of two or three days immediately prior 
to count and for two other days prior to the auditor's arrival in 
the general area. 

8. Test-check fed-in reports and reconciliations of enrichment con- 
centrates to determine that they are being prepared properly. 

9. Review office schedule of manufacturing adjustments. 

10. Examine condition of stock records : 

a. Are dates, including year, given on all records? 

b. Is work neat and accurate? 

c. Are papers filed for ready reference and to prevent loss? 

d. Are reports signed? 

e. Are adjustments clearly marked? 

11. Note physical condition of stock and properties. 

a. Is piling uniform? 

b. Are brands and sizes easily distinguished? 

c. Is quantity of broken and dirty bags and caitons large? 

d. Are returned stocks segregated and reconditioned promptly 
to avoid infestation? 



RICHLAND CORPORATION 121 

e. How often is mill fumigated? 

f . Is mill and/or warehouse reasonably clean? 

12. Examine latest schedule of old stock prepared by office. 

a. Review procedures for reporting old stock. 

b. List stock over sixty days old, based on local reports, in work 
papers and mention in report if quantity is excessive. 

B. Taken from the Management Guide Book of Personnel Policies and Pro- 
cedures, Stratford Foods, Inc. 

RECORDING ATTENDANCE 

Wage Employees at plants where time clocks are provided— workers register 
their own time on clock cards as they enter and leave the plant. Employees 
are not permitted to punch time clock cards more than 10 minutes before 
their regular starting time, and they must punch out within 10 minutes 
after their regular quitting time. In case overtime work is authorized, the 
employee must punch out within 10 minutes after completion of such over- 
time. This will effect substantial agreement between the time indicated on 
the clock card and the record of account distribution of time worked, which 
is approved by the foreman and is used as the basic record for payroll 
computations. 

C. Taken from the Manual of Payroll Procedures of Stratford Foods, Inc. 

WAGE PAYROLL 
e. Distribution to Employees 

( 1 ) Regular Weekly Distribution 

One individual is regularly assigned to distribute pay checks, but 
an additional person may be designated when it is necessary to 
accommodate employees at a plant operating more than one shift 
per day. Pay checks may be distributed by foremen, at the option 
of the division, but, if avoidable, they are not distributed by pay- 
roll department personnel. 

(2) Test Distribution 

At unannounced intervals as determined by the Division Controller 
or his representative, responsible administrative employees make 
periodic test distributions of pay checks averaging four times each 
year. If practical, the administrative employee should be ac- 
quainted with most of the wage employees, as the stock counter 
is in a food plant, but in no case are the test distributions made 
by a member of the payroll department. Two of the four distri- 
butions each year are formal and two informal, 
(a) When an informal test distribution is made, the following 

steps are taken: 

1. Upon receiving the checks, the employee who makes the 
distribution adds the amounts of the checks, and compares 
the total to the Pay Check Register. 



122 INTERNAL CONTROL AND INTERNAL AUDIT 

2. Each check is presented to the proper employee, and 
each employee is identified insofar as possible. 

3. Every check is distributed directly to the employee. 

(b) When a formal test distribution is made, the following steps 
are taken in addition to those listed under an informal 
distribution. 

1. As each employee is given his check, his signature is 
obtained on a worksheet, or on a copy of the Pay Check 
Register. 

2. The signatures secured are compared to the signatures 
appearing in the plant personnel files or to a file of W-4 
forms. 

D. Taken from the Manual of Cash Procedure of Stratford Foods, Inc. 

CASH DISBURSEMENTS 

I. General and Internal Control 

Accounting for cash disbursements involves certain fundamentals of 
internal check which cannot be ignored. The use of internal checks, 
whereby one individual verifies the work of another either directly 
or incidentally, is one of the best safeguards that can be established 
in expending cash with proper authority and for value received. 
In the Stratford organization, money is spent from the authorized 
funds through the general office, divisional offices, grain departments, 
branch selling offices, branch mills, and stores. The fundamental 
principles to be followed in safeguarding outgoing cash may be 
applied to each of the foregoing disbursing agents, although the 
routine of establishing internal check varies at several points in 
proportion to the size and type of the organization. 

1. Authorization to Disburse 

a. Whenever practical, the work of checking vendors' invoices 
and making applications to purchase orders should be assigned 
to an accounting employee who has no responsibility for 
purchasing. 

b. Before issuing a check, the disbursing cashier or clerk is 
required to obtain adequate supporting papers properly 
checked by authorized employees, who initial the supporting 
papers, ordinarily for each specific factor, and usually approved 
for payment by the proper executive, manager, or depart- 
ment head. Approvals, either on supporting papers or in 
auditing and approving the voucher, may be indicated by 
signed initials or a distinctive initial, but in no case shall 
approvals or evidences of check be indicated by a rubber stamp 
or a typewritten signature or initials. 

c. The person approving the invoice for payment should ne\ er be 
the disbursing cashier or clerk. 

II. Checking incoming merchandise before making payment 

Original copies of Material Received Reports and other evidences 



RICHLAND CORPORATION 123 

of receipt are routed directly to the accounting employee (with- 
out first going to the buyer). When the evidence of receipt has 
been carefully checked to the vendor's invoice as well as the Pur- 
chase Order and found in agreement, the accounting clerk indi- 
cates his initials in the space for Quantity. (If the original Material 
Received Report becomes lost, one of the duplicate copies of the 
original preparation should be used. A notation is made on the sub- 
stituted copy indicating that the original copy was lost. The file from 
which the duplicate copy is obtained should have a sheet inserted 
indicating the number, the vendor from whom received, the item 
received, a notation that the MRR copy is being used as a substitute 
for an original which was lost, and preferably a cross reference to the 
number of the voucher which it supports.) 

E. Taken from the Manual of Stock Control Procedures for Finished Products, 
of Stratford Foods, Inc. 

I. Production 

, 1. Registers for counting production 

Packing machines are generally equipped with double registers. 
One of the registers is set back to zero at the end of each order; 
it should be manipulated only to turn it back to zero. The 
manipulation of registers during packing operations to prevent 
them from tripping is not permitted. The second register is a 
cumulative one which is permitted to run without being set 
back. If practicable to do so, this register should be locked. 

Single registers may be used provided the stock control with 
only one register is satisfactory. The single register is to run 
cumulatively as described above for a second register. 

On the pony or pneumatic machines, packages which are cased, 
there should be a case register in addition to the single or 
double registers for sacks. The case register readings are used 
to govern the report of production, with the sack register reading 
being used as a check. The case register runs cumulatively as 
described above in the first paragraph. Differences based on 
readings of the two registers are investigated to determine 
whether sacks broken in packing represent the variation between 
the two registers. 

2. Tally forms for recording production 

A Packer's Tally, or Packing Order and Tally, is used to record 
quantities on products packed. If the first form is used, one is 
usually prepared for each packing machine operated for each 
shift and each packer. 

The Packing Order and Tally performs with one form the 
functions of the packing order and the packing tally; a complete 
tie-in of the two forms is thus provided. The planning depart- 
ment prepares the first five columns of the form avoiding the 
necessity of most of this information being copied on the packing 
tally in the mill. Provision is also made for recording the pro- 



124 INTERNAL CONTROL AND INTERNAL AUDIT 

duction of three shifts on the same form. There is, in addition, 
a column for recording hours expended, making it possible to 
compare man-hours to pack-out on a daily basis by packers or 
packing crews. It is designed to be used at one machine during 
the shift. 

3. Recording pack-out of packing machines 

On the basis of the Packing Orders, or the Packing Order and 
Tally, prepared by the Planning Department, the packing fore- 
man instructs the various packers as to the products each is to 
pack. 

If the Packing Order is used, the packer enters the following 
information on the Packer's Tally: 

1. Shipping order number (optional) 

2. Brand (If the brands to be packed are phosphated or 
self-raising products, they should be so identified. ) 

3. Grade 

1 4. Size of package 

5. Kind of package 

6. Opening register reading (for the first order) 

When a package is broken in packing and set aside to be 
repaired, re-sacked, or fed-in, it is reported on the register as a 
package packed. On the other hand, if the package is so badly 
damaged that the contents are emptied into the packer's weight 
box or lost as sweepings, the packer records this package as a 
torn package in the "Number of Torn Packages" column on the 
tally. In each of these instances it is assumed that the register has 
been tripped by the weight of the contents in the package which 
has been broken in packing. 

' When the order is completed (or part order if split between 
packers), the packer records the number of packages packed per 
the register, less the number of torn packages, on the Packer's 
Tally in the "Number of Packages Packed" column. The register 
is then set back to zero if there is a second, cumulative register 
on the machine. 

The cumulative reading of this second register is noted also 
when the order is completed and entered in the "End" space of 
the "Register Reading" column. The reading in the "Start" 
space is subtracted from it to secure the quantity packed per the 
cumulative register. This amount, which is entered in the 
"Difference" space of the "Register Reading" column, must agree 
with the sum of the entries in the "Number of Packages Packed" 
(in good order) column and the "Number of Torn Packages" 
column. This check should be made after each order is com- 
pleted. The closing register reading is then brought down on the 
next order line as the opening register reading of the next order. 
If there is only one register on the packing machine, this single 
register runs cumulatively, and the packer, at the beginning and 
end of each order or part order, records the opening and closing 



RICHLAND CORPORATION 125 

register readings on the tally. The difference between the two 
register readings is the number of packages packed per the 
packing machine register, and is entered in the "Difference" 
space in the "Register Reading" column. This difference, less 
the number of torn packages, should then equal the number 
of packages in good order packed out, and this number is 
entered by the packer in the "Number of Packages Packed" 
column. The closing register reading is brought down on the 
next order line as the opening register reading of the next order. 
Whenever practicable, the loading or warehouse crew should 
check the quantities packed, with the packing crew at the 
completion of each item. If an unreconcilable difference develops 
between the number of packages packed according to the 
registers and the quantity received by the loaders, the packer 
should immediately notify the packing foreman concerning the 
discrepancy. 

The cumulative register is the official authority for the count of 
packages packed. In case further investigation of a difference 
shows, however, beyond reasonable doubt that the production 
reported according to the register is incorrect, the production 
figure may be corrected. 

II. Fed-Ins 

The accumulation of broken packages should be avoided by feeding 
in the contents as soon as possible. All broken packages are considered 
as floor stock and hence carried on the stock ledger until actually 
fed-in. Particularly on the small sizes, it is desirable to provide 
receptacles about the mill into which the broken packages, subject to 
repair or repackaging are placed. Each day an employee should take 
the contents of each receptacle to the fed-in hopper for feeding in. 

III. Counting the Stock 

1. Frequency of counts 

To make the stock control system most effective in disclosing 
errors and irregularities, it is necessary to count frequently the 
stocks actually on the floor, compare the counts with the stock 
ledger balances, and investigate the differences so that the causes 
thereof may be located and eliminated. 

When differences between the counts and book balances are 
numerous and large, the stocks are counted daily, and differences 
checked promptly and thoroughly. The causes of differences should 
be eliminated as quickly as possible by proper action of the 
department or departments responsible for the weakness. 

When the system is functioning properly, however, the stocks ai'e 
counted only once a week, with an additional count at the end of 
the month. The weekly counts are made at the end of the week 
or when operating schedules give opportunity for counting while 
no production or loading is going on. Reconciliations of counts 
with stock ledgers should be made promptly. 



126 INTERNAL CONTROL AND INTERNAL AUDIT 

^ 2. Stock counters 

Accurate counting of stocks is essential to effective and economical 
operation of the control. The stock counter should, therefore, be 
alert, observing, and accurate in mathematical computations and 
recording information. 

Because familiarity with the plant and the stock aids materially 
in counting correctly, it is advisable that the same man count the 
stocks every time. Occasionally, at the end of the month, it is 
helpful to have an extra man work with the regular counter to 
check his count, calculations, and the recording by keeping a 
separate record of the count and comparing it with the counter's 
■ record. 

In making the counts, there is need for close cooperation with the 
Manufacturing Department in order that the stocks may be 
counted more readily. The stock counter can perform his function 
better if stocks are piled in an orderly fashion, and he is dependent 
on the Manufacturing Department for this aid. 
Since the stock counter performs a function of accounting control, 
he should be responsible to the ofBce manager, and not in any 
way responsible to the plant superintendent or the packing and 
loading foremen. The stock counter and the operating personnel 
should be mutually helpful, but the counter should be free of any 
control by the operating personnel. In accordance with this 
principle, the counter is not assigned to work in an operating 
department. If at all possible, the stock ledger clerk does no stock 
counting. 

3. Comparisons with books 

The stock books should be posted and balanced as soon as possible 
after the cut-off, so that the count can be compared with the books. 
When the stock counter has completed and totaled this count and 
the stock ledger clerk has computed his balances, the count should 
be checked against the stock ledger. The development of the memo 
stock records by the counter for comparison with his stock count 
prior to checking with the stock ledger is not permitted. 
The stock clerk may alone compare the count with the stock 
ledger, or the stock counter may call the count to the stock clerk. If 
there is a difference between the count and the book balance, the 
amount of the difference not accounted for is written in the 
"Variations" column of the stock ledger, opposite the balance, and 
also written in the "Over or Under Book" column of the Mill Stock 
Count. When the count and book balance agree, a check mark or 
dash is placed opposite the balance on the ledger to show that the 
count agrees. 

Under the procedure by which "date order" and "track" cars set 
on the hold tracks remain in the mill stock ledger until switched 
from the company's yards, there is a difference between the actual 
floor count and the stock ledger to the extent of those cars. The 
stock in "date order" and "track" cars is either coded as such in 



RICHLAND CORPORATION 



127 



the "Floor Count" column of the Mill Stock Count Sheet or is 
listed on special inventory sheets. This avoids the possibility of 
confusing stock available for filling orders and that which is in the 
process of being shipped from the mill. 

The form, Hold Track Cars Still in Stock, may be used for making 
this special inventory listing, if desired. (At the end of the month, 
this form is prepared in duplicate.) This form is prepared by the 
Loading Department each time a floor count is taken, and is 
prepared from the loading records being held until the cars are 
switched from the hold tracks. The individual items on the loading 
record copies are entered on the Hold Track Cars Still in Stock 
form by shipping order number, brand, size, and number of 
packages. Similar brands and sizes on different shipping orders are 
entered in the same column. The columns are then totaled and the 
form sent to the stock ledger clerk, who uses it to explain stock 
differences due to cars on the hold tracks. The difference between 
the stock ledger and floor count shown in the "Variation" column 
of the ledger and the "Over or Under Book" column of the count 
sheets should be the net difference after considering the assortment 
on the Hold Track Cars Still in Stock. The totals of this latter form 
are not indicated on the Mill Stock Count Sheets. At the end of the 
month, a carbon copy of Hold Track Cars Still in Stock accompanies 
the floor count sheets sent to the individual in the mill adminis- 
trative office checking the accuracy of the inventory. 



EXHIBIT 2 

Organization of Stratford Foods, Incorporated 



PRESIDENT 
STRATFORD FOODS, INC 



PRESIDENT'S STAFF 



DIVISIONAL CHIEF EXECUTIVES 



OTHER 
STAFF 
MEN 



CONTROLLER 



VICE PRESIDENT 

IN CHARGE OF 

SALES 



VICE-PRESIDENT 

IN CHARGE OF 
MANUFACTURING 



RICHLAND 

CORPORATION 

CHIEF 

EXECUTIVE 



COLEMAN 
PROCESSING 

CHIEF 
EXECUTIVE 



OTHER 
STAFF 
MEN 



RICHLAND 
CONTROLLER 



RICHLAND 

VICE-PRESIDENT 

IN CHARGE OF 

SALES 



PLANT ACCOUNTANTS 



u 



OTHER 

CHIEF 

EXECUTIVES 



RICHLAND 
VICE-PRESIDENT 
IN CHARGE OF 
MANUFACTURING 



OTHER DIVISIONS 

(all have ORGANIZATIONS 

SIMILAR TO RICHLAND) 



rC:;i;x;i;7[;7rp 



PLANT MANAGERS 



CTTT^ 



DIVISIONAL SALESMEN 



case 



13 



NORTHERN ALLIANCE COMPANY 

Internal Audit Report 

In this case the problem of how to present findings of an internal 
audit report is raised. The student is asked to relate the significance 
of findings to the need and objectives of the reporting procedure. 

The Northern AHiance Company was a subsidiary of Stratford 
Foods, Incorporated, one of the largest producers and distributors 
of food items in the United States with sales offices throughout the 
world. Northern Alliance, as did most of the Stratford subsidiaries, 
sold primarily to retail food outlets, both grocers and restaurants. 
The subsidiary serviced the North Central area of the United States. 
Its operations consisted of buying raw produce— and some canned 
goods as well— and processing and packaging the raw food items 
into the form commonly seen on grocers' shelves; storage and dis- 
tribution were also a vital part of the firm's activities. 

On April 1, 1948, Northern Alliance opened a new plant and office 
in Toledo, Ohio. The management of Stratford Foods, Inc., in order 
to form some appraisal of the progress being made by the Toledo 
plant, requested the Internal Auditing Department to perform an 
audit after the first four months of the plant's operations. As can be 
seen in the audit report which is reproduced below, the plant had 
experienced some difficulty in getting production under way. Per- 
sonnel were new to their jobs and several mechanical problems were 
encountered in the production facilities. In addition, a shortage of 
trained clerical personnel hampered the establishment of an ade- 
quate office staff. 

Exhibit I of the Richland Corporation case presents excerpts from 
the Stratford Foods manuals on internal auditing which pertain to 
the accounts mentioned in the "Tentative Audit Report " reproduced 
below. 

128 



NORTHERN ALLIANCE COMPANY 129 

Tentative Audit Report of Northern Alliance Company 
Toledo, Ohio, Mill and Office, October 31, 1948 

General Condition of Office 

Although most phases of the accounting were appraised as having 
been performed in a generally satisfactory manner and the clerical 
work was notably free of exceptions, unfavorable results reflected 
by the accounting controls for the major operating functions ( which 
involved a large percentage of the total accounting eftbrt) and 
numerous, although generally not overly significant, weaknesses in 
accounting procedures and internal controls were noted. 

The deficiencies noted in the review of this initial period of opera- 
tion were somewhat extensive and detracted significantly from the 
otherwise generally favorable performance noted. However, these 
weaknesses were ones of which management was well aware and 
toward which a continuing program of corrective action had been 
and was currently being directed. 

Except for the fact that the relative scarcity of accounting per- 
sonnel at Toledo complicated the achieving of adequate internal 
controls in some instances, it appeared that the needed refinements 
in accounting procedure could be effected without particular 
difficulty. 

1 . Plant Blocks 

a. Finished Products — Fair. Net cumulative unexplained stock 
adjustments were somewhat large, totaling an overage of 2,583 cases 
during the eight months ended November 30, 1948. Individual ad- 
justments were also large, overages and shortages totaling 9,100 
cases during this period, precluding a satisfactory and current con- 
trol over the stocks. 

Deficiencies in production reporting procedures and in loading 
operations appeared primarily responsible for the performance 
noted. Official production data reported by the assistant packing su- 
perintendent represented the employees' best judgment after com- 
paring the total production indicated by registers in case sealers 
with the production by brands and sizes indicated by tow-motor 
operators' reports. The differences between these two sources of 
data were numerous, and belt registers were to be installed to obtain 



130 INTERNAL CONTROL AND INTERNAL AUDIT 

a more reliable breakdown of production by brands and sizes. A 
weakness in internal control appeared to stem from the practice of 
notifying the assistant packing superintendent of daily stock differ- 
ences and from failing to require for the office files any original 
source date to support the daily reports of production received from 
him. 

Approximately one-third of the total stock adjustments had re- 
sulted from loading errors made in one month and corrected in 
another. Although only about twenty-five per cent of the mill ship- 
ments were made in pool cars, more than fifty per cent of the mis- 
loadings involved pool car orders. Seventy per cent of the reported 
loading errors and of the stock quantities involved therein repre- 
sented shortage claims, and it appeared not unlikely that many 
overloadings had not been reported and that the shortage adjust- 
ments attending these overloads were being more than offset by 
overages resulting from unrecorded production— a net cumulative 
overage of about 2,600 cases having been reported during the eight 
months ended November 30, 1948. 

Production Reporting 

Package food production was recorded by (a) case sealer registers 
and ( b ) records of cases warehoused as determined from tow-motor 
operators' reports of product transferred to the storage area. These 
two sources of production data were compared by the assistant pack- 
ing superintendent, and a third report— called a daily packing re- 
port—was prepared by him, representing his best judgment ( after the 
aforementioned comparison) as to the quantity of finished products 
produced. The quantities he reported were recorded in the official 
stock ledgers. The two original recordings of production were re- 
tained for approximately one week by the assistant packing foreman 
before being destroyed, and were not made available to the stock 
ledger clerk to support the daily packing report. A significant weak- 
ness in the control over reported production existed in that the 
stock ledger clerk communicated daily stock differences to the as- 
sistant packing superintendent. Possibly, this impaired the superin- 
tendent's judgment in appraising the accuracy of sealer register 
readings and tow-motor operators' reports, and prevented the dis- 
closure of legitimate stock differences. 

Inasmuch as two of the three sealing machines in operation serv- 



NORTHERN ALLIANCE COMPANY 



131 



iced more than one size and brand of product, these case sealers 
necessarily recorded total production only (except for three reg- 
isters that were so placed on one sealer as to record the larger cases ) . 
The detail of pack-out by brand and size was therefore determined 
from quantities accounted for by the tow-motor operators' pallet 
tickets. The reconciliation of pallet tickets with register readings 
taken by the auditors for a two-day period disclosed several rather 
large differences between these two records of production, as well 
as differences in readings of registers on the same sealing machines. 
(Three registers were attached on each of two sealers, and five 
registers on the third sealer. ) A summary of these differences is pre- 
sented in the following table. 





December 8 Production 


December 9 Production 




Per 
Pallet 
Tickets 


Per 
Register 
Readings 


Per Daily 
Packing 
Report 


Per 
Pallet 
Tickets 


Per 

Register 
Readings 


Per Daily 
Packing 
Report 


Sealer #1 

( Assorted Sugars ) 


470 


463 
467 
467 


467 


452 


501 
501 
501 


500 


Sealer #2 
(Salt) 


4,796 


4,174 

4,177 
4,942 


4,796 


3,461 


3,523 
3,524 
3,528 


3,521 


Sealer #3 
(CoflFeepak) 


1,719 


1,777 
1,778 
1,779 


1,777 


1,664 


1,682 
1,683 
1,683 


1,682 


Total 


3,221 


3,282 
3,283 


3,279 


3,633 


3,646 
3,647 


3,636 



In order to provide a more detailed record of production by in- 
dividual sizes and brands— on the basis of automatic registers— it was 
stated that belt registers were to be installed on the packing lines. 
One such register was currently in operation. 



Loading Operations 

Approximately 35% of all stock adjustments (9,100 cases) of 
package foods occurring during the eight months ended November 
30, 1948, resulted from car loading errors made in one month and 



132 



INTERNAL CONTROL AND INTERNAL AUDIT 



for which biHings were adjusted in another. Although pool car ship- 
ments accounted for approximately 25% of total shipments from 
the Toledo plant, more than 50% of the reported car loading errors 
—171 during the eight months period— were claims involving pool 
car loadings. (Certain of these claims, however, undoubtedly were 
attributable to inaccuracies in unloading rather than in loading cars. ) 
Ten per cent of the total errors reported involved "balance items"— 
items on which loaders determined the quantities to be shipped on 
the basis of cases required to complete a car to physical capacity. 

Approximately 70%, of both the number of reported car loading 
errors and the quantities misloaded involved shortage claims, and it 
appeared not unlikely that all overshipments were not being re- 
ported and that stock shortages resulting therefrom were being off- 
set by overage adjustments developing from production reporting 
deficiencies. 

An average of 140 cars were loaded monthly at the Toledo plant. 
Except for minor quantities of by-products, no shipments were made 
by truck. 

SCHEDULE 1 

Summary of Stock Adjustments and Production 
Package Foods— For the Eight Months Ended November 30, 1948* 



Total 8 Months Ended Nov. 30, 1948 

November, 1948 

October 

September 

August 

July 

June 

May 

April 

* Figures in equivalent cases. 



Stock Adiiistment 



Net 



2,583 
614 

-207 

-168 

33 

551 

1,358 

421 

-19 



Total 



9,100 

1,134 

683 

768 

711 

2,071 

3,031 

675 

27 



Production 



1,369,776 
175,236 
186,895 
201,389 
239,663 
253,152 
196,946 
90,627 
25,868 



2. Control over Coupons— Fair 

Large overages, rather than normally expected shortages, of those 
coupons used with mechanical coupon droppers (all but Coffeepak 



NORTHERN ALLIANCE COMPANY 



133 



coupons) had been experienced during the audit period, amounting 
to 484,700 sugar coupons (5.4% of usage) and 111,500 salt coupons 
(3.1% of usage) for the five months ended November 30, 1948. The 
reported overages appeared principally attributable to the failure 
of automatic droppers, because of mechanical difficulties, to insert 
coupons in numerous packages. The auditors' tests of automatic 
coupon dropper insertions during a three-day period is summarized 
in the following tabulation: 



Item 


Consecutive 
Packages 
Counted 


Packages 

Coupons Not 

Inserted 


Salt 

Oatmeal Cookies 


100 
200 
100 

543 
300 

350 
200 
200 

300 
200 
250 


2 

60 

1 

238 


Kiddy Kookies 

Sugar 


32 

69 
55 
30 

94 
4 
4 



Coupons were inadvertently not being inserted in oatmeal-cookie 
packages during one of the auditors' test counts. This situation had 
apparently developed from the failure to watch closely, and re- 
plenish when exhausted, the small supply of coupons held by the 
dropper. (Insert-type coupons have been discontinued in favor of 
label-imprinted coupons, subsequent to the auditors' observations.) 
Instances were also noted in which more than one coupon was in- 
serted in packages, the printing ink apparently causing coupons 
frequently to adhere to each other. 

Contrary to the large overages of mechanically inserted coupons, 
consistent large shortages of manually inserted coupons (Coffeepak 
only) were noted, totaling 51,400 coupons, or about 4.3% of usage, 
during the five months ended November 30, 1948. 

The physical control over coupons appeared adequate. Locked 



134 INTERNAL CONTROL AND INTERNAL AUDIT 

storage space was provided for all coupons except those which were 
part of the package printing. 

Although several minor procedural deficiencies were noted in the 
accounting for coupons, this phase of the work appeared to have 
been generally performed satisfactorily. 

Manual instructions relating to coupon control as recently issued 
by the methods department were not on file in the Toledo office. 

Remarks. Although involving generally minor quantities, coupons 
released from fed-in operations were not accounted for on the recon- 
ciliation record. 

Manual instructions relating to coupon control were not on file in 
the Toledo office. 

Ledger accounts were maintained and posted daily for each cou- 
pon series to provide operating data. 

The physical control over coupons appeared generally adequate. 
Locked storage space was provided for all coupons except for those 
imprinted on labels. 

Spoiled coupons and labels with coupon imprints were burned 
daily. 

A summary of reported coupon differences is presented in Sched- 
ule 2. , 

3. Mill Payroll— Good . 

Principal Weaknesses or Exceptions. Numerous instances in which 
employees were punching in more than ten minutes before starting 
times were noted during the auditors' reviews of one week's payroll. 
(A notice prohibiting this practice was posted during the audit.) 

Contrary to manual provisions no test distribution of pay checks 
had been made during the first eight months of operations, and one 
unclaimed wage payroll check ( 130 days old when noted by the 
auditors ) had not been cancelled after sixty days had elapsed. ( Pay- 
rolls were regularly distributed by foremen. ) 

Remarks. Although approvals on time cards appeared generally 
satisfactory, it was noted during a review of the time cards for three 
payroll periods that foremen's approvals were lacking in eight in- 
stances for daily hours worked, and an omitted punch-out time had 
not been noted by the foreman. 

The Manual of Payroll Procedure had not been made available to 
the Toledo plant. 



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136 INTERNAL CONTROL AND INTERNAL AUDIT 

4. Miscellaneous Accounts Receivable— Good 

Principal Weaknesses or Exceptions. The internal control over 
miscellaneous accounts receivable was weakened through concen- 
trating in a single employee the responsibilities for ( 1 ) maintaining 
these receivable records, (2) invoicing the purchasers for the ma- 
terials sold, (3) making and approving sundry journal entries af- 
fecting these accounts, and (4) receiving mail remittances from 
purchasers without a prior recording of such remittances being 
prepared. 

Remarks. The small number of office personnel explained, in part, 
the concentration of duties that existed. 

The balance in Miscellaneous Accounts Receivable as of October 
31, 1948, totaled $488.70, of which $330.00 represented a charge for 
equipment returned to a vendor for credit, $46.00 represented 
deposits on containers, and $112.70 represented the amounts accru- 
ing from the sale of scrap containers during the month of October. 

Assume that all accounts not mentioned in the report are satisfac- 
tory. Prepare a summary of the audit report you would send to the 
Northern Alliance chief executive and to the Stratford Foods Man- 
agement. 



case 



14 



THE DOLPHIN MANUFACTURING COMPANY 

The Internal Audit Follow-up 

This case considers the effectiveness and suitability of the use of 
an internal department as the "eyes and ears" of management in 
planning for control in a decentralization operation. 

From the date of its founding in the early 1900's, The Dolphin 
Manufacturing Company had proved unusually successful. Largely 
family owned, the company grew and prospered until, with its diver- 
sified line ranging from farm machinery to earth-moving equipment, 
it had become one of the leading industrial equipment manufacturers 
in the country. In the middle 1940's, however, the time seemed ripe 
for a substantial change in management and such a change was 
consequently engineered under the leadership of Robert Wyman, 
who at that time had taken over the presidency of the company. 
This new management inaugurated a plan of managerial and finan- 
cial controls such as the company had not previously known. 

Prior to 1946 there were few formal control devices, since for many 
years the management of the company had been dominated by the 
strong personality of the founder. Consequently, managerial and fi- 
nancial responsibilities were highly centralized in the company's 
home offices in Chicago. The company possessed in this older era 
only one set of books, maintained in the Chicago offices, and had 
never been concerned with such formal control devices as organiza- 
tion charts or accounting manuals. The changes beginning in 1946, 
leading to a decentralization program somewhat along the organ- 
izational lines of General Electric or General Motors, were, there- 
fore, of far-reaching consequences to the entire company. 

In keeping with this movement towards decentralization, the 
company's operations were divided into divisions, these divisions 
having under their jurisdiction various manufacturing plants, as- 
sembly plants, and parts depots. The divisions and plants were es- 
tablished as profit centers with responsibility delegated to local 

137 



138 INTERNAL CONTROL AND INTERNAL AUDIT 

management to earn a suitable return upon the company's invest- 
ments in the assets charged to these various divisions and plants. 

The accounting organizations within these divisions and within 
the plants became autonomous units. It was the responsibility of 
these accounting organizations to perform all the accounting func- 
tions pertaining to the activities of these autonomous units, except 
for such activities as the preparation of tax returns which was 
handled on a company- wide basis. Nearly 100 different accounting 
locations were established, and the accounting procedures at these 
locations were performed in accordance with instructions prescribed 
by the home office in the Controller s Manual. However, where neces- 
sary or appropriate, the various divisions were expected to write 
supplementary accounting procedures governing their distinctive 
needs. Monthly financial and operating statements were submitted 
from each of these nearly 100 accounting units. 

In addition to the inevitable accounting problems contingent upon 
the company's adopting decentralized management direction of op- 
erations, Mr. Wyman faced the further problem of establishing ef- 
fective company- wide respect for and cooperation with the activities 
of the accounting and financial departments. In past years these 
groups had been relegated to a very subordinate position in the 
company's organizational scheme of operations. The details and 
technicalities involved in the renegotiation and settlement of the 
company's war contracts provided Mr. Wyman with an excellent 
excuse for commissioning a nationally-known firm of public ac- 
countants to make an audit of all company assets and liabilities; an 
audit by public accountants had never been previously made. 

In order to capitalize upon the activities of the public accountants, 
as well as to make future provision for a continuous review and ap- 
praisal of the company's revitalized accounting operations, an in- 
ternal audit department was established. Previously, there had been 
a small internal audit department but its activities were limited due 
to inadequate personnel and lack of management acceptance. 

The objectives of the reorganized internal auditing department 
were set forth in the company's Organization Manual as follows: 

1. Develop and conduct an internal auditing program, comprising the 
systematic examination of accounting methods and related procedures 
and the verification of records and financial statements on a company- 



THE DOLPHIN MANUFACTURING COMPANY 139 

wide basis, to assure that the financial condition and operations of the 
company are accurately and uniformly reported. 

2. Determine whether established financial and accounting policies and 
procedures are being observed, and if adequate controls and reports are 
maintained on all company assets and operations. 

3. Recommend revisions in accounting policies, procedures, controls and 
related matters, where such revisions will improve the accuracy or value 
of records and reports required in measuring the company's financial 
status and operating results. 

4. Prepare and submit reports of audits conducted under the company-wide 
internal auditing program, and review reports of remedial action taken 
thereon. 

5. Functionally supervise the internal auditing activities of the divisions, 
including the scheduling and scope of divisional audits in order to assure 
maximum effectiveness in audit coverage. 

6. Coordinate internal auditing activities with outside auditors engaged by 
the company. 

The senior public accountant, Mr. Paul Robey, who had been in 
charge of the 1946 audit of The Dolphin Manufacturing Company 
by the public accountants, had so impressed the company's man- 
agement by his tact and competence that he was asked to head the 
internal audit department. As general auditor, Mr. Robey was one 
of three persons who reported directly to Mr. Averett, the vice- 
president of finance— the other two were the treasurer, Mr. Jones, 
and the controller, Mr. Roberts. 

The treasurer's duties were primarily those of cash management. 
These duties included banking arrangements and relationships, 
credit and collection policies, and the employment of surplus funds 
through the purchase, custody, and sale of securities. 

The controller was responsible for all accounting activities. The 
controller's office, through the medium of the Controller's Manual, 
issued instructions governing both accounting procedures as well as 
the maintenance of the company's system of internal control. Final 
consolidated financial statements and company-wide financial and 
operating analyses were prepared under the direction of the central 
controller's ofiice. 

The general auditor, on the other hand, had no direct responsibility 
for or direct authority over the accounting operations, since his po- 
sition was regarded solely as one of review, criticism, and suggestion. 
However, the general auditor was free to conduct his audits in any 
area of the company's activities at any time. Between the treasurer, 
the controller, and the general auditor, close liaison was maintained 



140 INTERNAL CONTROL AND INTERNAL AUDIT 

at all times. (For a more complete description of the organizational 
responsibilities of the controller's department, see Exhibit 1. Note 
the office of Audit Coordinator under General Accounting. ) 

EXHIBIT I 

Organization Chart— Finance Department 



VICE-PRESIDENT 
FINANCE 



TREASURER 



CONTROLLER*] 

I 



GENERAL AUDITOR 



ADMINISTRATIVE 
ASSISTANT 



ASSISTANT CONTROLLER 



ASSISTANT CONTROLLER 



SPECIAL 
ASSIGNMENTS 



POLICIES AND 
SYSTEMS 



COST 
DEPARTMENT 



GENERAL 
ACCOUNTING 



AUDIT 
COORDINATOR 



FINANCIAL 
STATEMENT 



PROPERTY 
ACCOUNTING 



DEFENSE 
CONTRACT 



OPERATIONS 
ANALYSIS 



TAX LIAISON 



PRODUCT 
ANALYSIS 



FORECAST 



PRICE 
ANALYSIS 



SPECIAL FINANCIAL 
PROJECTS 



CAPITAL INVEST- 
MENT ANALYSIS 



PRESENTATIONS 



GENERAL 
OFFICE 



Dotted line relationship with controllers in decentralized operating units. 



The general auditor's office comprises the general auditor, an as- 
sistant general auditor, one staff assistant, three section supervisors, 
thirty field auditors, and the necessary secretarial and typing person- 
nel. Internal audit personnel have thus far been obtained primarily 
from the field of public auditing, although two of the present staff 
have been temporarily transferred from the controller's department 
for the "broadening" experience inherent in the internal audit ac- 
tivities. Also within the last two years better than fourteen of the 
audit group have been transferred from the internal audit staff to 
positions of equal or greater responsibility in the controller's organ- 
ization, either at the home office or at the divisional or plant level. 
The general auditor has welcomed this use of the audit program for 
training purposes. 



THE DOLPHIN MANUFACTURING COMPANY 141 

At present Mr. Robey uses mostly seniors and semi-seniors in his 
field audits on the theory that too many untrained juniors put too 
much strain upon the senior staff. The field auditors travel in two- or 
three-man teams and are frequently away from the home office for 
as much as a year at a time. An annual get-together has recently been 
instituted, therefore, in order to bring the men back to headquarters 
for a week of both social activities and of round-table talks, the 
latter being aimed at a constructive analysis of the internal audit 
program by varying company officials representing a diversity of 
viewpoints. An audit manual, including basic audit programs, is in 
use to provide thorough and consistent coverage, although consid- 
erable latitude in making an investigation is still left to the individual 
auditor. Careful attention is also paid to appraising the effectiveness 
of the system of internal control developed at each of the audit 
points. 

Mr. Robey has instructed the auditors to discuss their findings 
with management at the plant levels in the course of the examination 
both to insure factual accuracy and to keep plant personnel abreast 
of audit developments. The internal audit team also attends the post- 
audit management meetings at which the auditors' findings are dis- 
cussed preparatory to the drafting of the formal audit report ad- 
dressed to Mr. Averett, the vice-president of finance. 

Mr. Robey has described his internal audit procedures in the fol- 
lowing fashion: 

For the most part, our audits of operating locations ai-e over-all audits 
covering every phase of the accounting activity within the operation. On 
occasion, reviews are made covering only certain specific phases of an activity. 
Such reviews are referred to as feature audits. 

We use an audit manual as an aid in performing our audit function. This 
manual describes the general objectives and the plan of operation of the 
auditing department. In addition, it includes three standard audit programs- 
one pertaining to our manufacturing operation, one pertaining to our assembly 
operations, and another to our parts depot activities. As these major activities 
vary widely in character, we believe that greater efficiencies are realized 
through directing our programs toward each type of activity. These programs 
are modified, as necessary, to meet specific circumstances. We try to avoid 
auditing in detail unless circumstances require that it be done. We believe that 
much of the detailed checking which might be done as part of an audit should 
be done as a part of the regular accounting routine. During our audits, we 
determine that the necessary account analysis and detailed verification steps 
are performed as a part of the accounting function. 

We continuously stress the fact that our audit programs are to be used for 



142 INTERNAL CONTROL AND INTERNAL AUDIT 

guidance, that completion of the work called for by the program does not 
necessarily mean satisfactory completion of the audit, and, conversely, satis- 
factory completion of certain audits does not necessarily require full compli- 
ance with all steps set forth in the program. Our supervisors review, with the 
auditor in charge, any steps omitted in the course of the audit and any 
additional steps considered necessary. Because of the newness of our accounting 
system and the steady flow of accounting instructions and procedures further 
refining this system, it is necessary that our audit programs be consistently 
reviewed in order that they may be maintained on a current basis. 

A formal audit report is issued covering each audit assignment. Our reports 
are narrative in form and rarely include any financial statements or schedules. 
The typical audit report covering an accounting location includes a brief 
introduction; a description of the scope of the audit, citing the principal areas 
covered and any areas which might have been omitted for one reason or 
another; and our comments pertaining to the audit findings. We do not report 
minor errors and clerical mistakes unless their frequency indicates definite 
weaknesses in organization, procedures, or internal control. Each audit finding 
is discussed separately, stating the conditions noted, any circumstances which 
might contribute to the condition, and the accounting instruction or procedure 
which may have been violated. If corrective action in whole, or in part, is taken 
by the location during the course of the audit, a statement to this efi^ect is made 
in the report. Each audit finding is followed by our recommendation as to the 
corrective action which should be taken. Our reports contain comments per- 
taining only to those items which are in need of corrective action. In other 
words, we always report on the deficiencies and rarely, if ever, give praise. 

We devote a great amount of time to the preparation of audit reports. Various 
sections of the report are prepared in the field by the man doing the work. 
The report is reviewed by the section supervisor. It is again reviewed and 
edited by myself, or the assistant general auditor. Great care is taken to avoid 
personal criticism, and every precaution is taken to assure that all statements 
are based on facts— not suppositions. 

During the course of the audit, all findings are discussed with the local 
controller or his representatives. At the conclusion of the field work, we hold 
what we refer to as an "Audit Conference." This conference consists of a 
meeting attended by the senior auditor who conducted the audit, the section 
supervisor, and, if possible, myself or my assistant, together with the plant 
manager, plant controller, and such other individuals as they may wish to have 
attend. At this meeting, the draft of the report to be issued is read, and 
whatever discussion is necessary takes place in order to establish as facts the 
findings enumerated in the report, and to obtain agreement by the location 
being audited that conditions are as reported. Our plant managers take a 
keen interest in these audit conferences. 

Our reports are addressed to the vice-president in charge of finance, who 
receives one copy. Copies of the report also go to our public accountants and 
to the manager of the division in which the particular operation is located. 
A number of copies, depending upon the needs of the particular division, are 
submitted to the central controller's office. The central controller's office 
distributes these reports to the division which, in turn, furnishes the plant 
with the necessary copies. 



THE DOLPHIN MANUFACTURING COMPANY 143 

The following is a recent audit report taken from the files of the 
internal audit department of The Dolphin Manufacturing Company: 

Distr: 1 Averett 

13 Controller 
1 Public Acc'ts 
1 Division Mgr. 

BALTIMORE MANUFACTURING PLANT 
Atlantic Division 



As of January 31, 1951 



Mr. R. G. Averett 
Vice-President— Finance 



April 25, 1951 



Dear Sir: 

An audit has been made of the Baltimore Manufacturing Plant, Atlantic 
Division, as of January 31, 1951. The field work was performed by Mr. C. W. 
Smathers and one assistant during the period from February 12, 1951, to 
April 25, 1951. The accounting work at this location is under the direction ot 
Mr. E. A. Hugh, Plant Controller. 

Scope 

The examination covered the period from March 31, 1950, the date of the 
last audit, to January 31, 1951, with attention directed, for the most part, to 
procedures followed and transactions recorded in the latter part of the period. 
In some instances, transactions occurring in February and March, 1951, were 
also examined. Confirmations of working fund and payroll bank account 
balances were obtained independently from the depositary as of January 31, 
1951, and reconciliations prepared by local personnel as of that date were 
reviewed and tested. Intra-company accounts receivable were traced to 
settlement certificates. Outside accounts receivable were confirmed by direct 
correspondence with customers. 

Inventory accounts were reviewed and test-checks made of recorded trans- 
actions. Productive material cost records were tested, and procedures fol- 
lowed in compiling costs of assemblies and individual parts were reviewed. 
Quantities of selected items of steel wire stock on hand were counted and 
compared with quantity balances reflected on inventory records. 

In regard to our examination of fixed assets, tests were made of additions, 
retirements, and depreciation provisions, and routines were reviewed for 
conformance with established project procedures. Comments regarding this 
phase of the examination are included under Paragraphs I-A and 1-B of this 
report. 

The propriety of payments to vendors and the related accounting distri- 
bution was tested against supporting documents. Computations of accrued 
payrolls, taxes, and other liabilities were also tested. Sales and cost of sales were 
reviewed and representative tests made of underlying records. 



144 INTERNAL CONTROL AND INTERNAL AUDIT 

Throughout the examination, special emphasis was directed toward deter- 
mining the degree of internal control existing in procedures currently being 
followed. Also, the charts prepared by this location, in accordance with the 
Company's internal control review program, were tested to procedures in 
effect. Exceptions noted are commented on in Paragraph IV of this report. 

Where necessary, reference is made in this report to Accounting Manual 
procedures as we have been informed that such procedures are to remain in 
effect pending the development and issuance of accounting and operating 
instructions by the Atlantic Division. 

Results of Examination 

The matters which are believed to be of special interest are outlined, as 
follows, with the supporting explanatory paragraphs indicated. 

Recommendations Paragraph 

Construction in Progress Account Not 

Cleared Promptly I-A 

Delays in Recording Retirement Transactions I-B 

Badge and Tool Clearance Procedure Not 

Properly Followed II 

Sales Taxes Incorrectly Accrued Ill 

Need for Strengthening Internal Control IV 

DETAILED COMMENTS 
I. Fixed Assets 

A. Construction in Progress Account Not Cleared Promptly— Findings 

As of January 31, 1951, there were approximately 100 projects, completed 
from three to twelve months previously, for which accumulated costs had not 
been cleared from the construction in progress account (lA 74-lA). Although 
these projects involved expenditures of less than $1,000 in each case, it is 
important that all acquisition costs be transferred promptly to ultimate fixed 
asset accounts so that depreciation may be properly computed and accurate 
property records provided. 

Recommendations 

\t is recommended that the costs of all completed projects be cleared from 
construction in progress to ultimate fixed asset accounts as soon as possible. 
In the future, acquisition costs should be transferred to ultimate fixed asset 
accounts promptly after projects are completed. 

B. Delays in Recording Retirement Transactions— Findings 

The examination of machinery and equipment retirements disclosed excessive 
delays in recording transactions in the retirement clearing account. For example, 
in the case of three disposal authorities covering property costs approximating 
$216,000, transfers from the fixed asset account to the retirement clearing 
account had not been effected as late as February 28, 1951, although work 



THE DOLPHIN MANUFACTURING COMPANY 145 

order charges indicated that dismantlement had been commenced as far back 
as April and October, 1950. In another case, proceeds from the sale of equip- 
ment were recorded in September, 1950, but the asset costs had not been 
transferred as of February 28, 1951. 

In several instances, no entries were recorded to credit the retirement 
clearing account and charge scrap income for the estimated salvage values 
shown on disposal authorities. In other cases no dismantlement costs were 
recorded, although the disposal authorities indicated that such costs were 
anticipated in connection with the retirements. There were also inconsistencies 
in the handling of transfers from the retirement clearing account to the 
depreciation reserve account. In this connection, certain balances representing 
dismantlement charges and salvage credits were being carried in the retirement 
clearing account at January 31, 1951, although the costs of the related assets 
retired had been transferred to the reserve account several months earlier. 

Recommendotions 

It is recommended that the retirement clearing account be analyzed, and 
necessary entries recorded to effect transfers of property costs from the fixed 
asset accounts. In the case of retirements which have been completed, all costs 
and salvage credits should be cleared to the applicable depreciation reserve 
accounts. In the future, close follow-up of disposal authorities and periodic 
analyses of retirement clearing accounts should be maintained so as to insure 
that all retirement transactions are reported and handled on a current basis. 



II. Salaries and Wages 

Bodge and Tool Clearance Procedure Not Properly Followed— Findings 

In order to prevent employees from claiming final pay checks without 
obtaining badge and tool clearances. Standard Procedure II, c, 2— R requires 
foremen to write "Hold" on the checks of all employees who have not worked 
at least seven hours during the week in which the roll is paid. Tests of un- 
distributed hourly payroll checks for the pay period ended March 4, 1951, 
disclosed 27 cases where foremen had failed to designate those checks to be 
held, although the employees' clock-cards indicated that no hours had been 
worked in the succeeding week during which the roll was paid. Since Standard 
Procedure II, c, 2— R has replaced the timekeeper's "five-day list" as a means 
of preventing employees from leaving the Company without badge and tool 
clearances, it is important that foremen discharge their responsibilities under 
this procedure. 

In certain cases, payroll checks not requested by foremen are transmitted 
directly by the payroll section to the unclaimed pay custodian. There was no 
procedure in effect to cover the identification and withholding of checks in 
those cases where employees had not worked the required number of hours in 
the week during which the roll was paid. 

Action Token 

The payroll supervisor issued instructions that all checks not requested bv 
foremen are to be compared with timekeeping records before being transmitted 



146 INTERNAL CONTROL AND INTERNAL AUDIT 

to the unclaimed pay custodian. Also, these checks are to be marked "Hold" 
in those cases where employees have not worked the required number of hours. 

Recommendotions 

It is recommended that plant management take the necessary steps to insure 
that foremen are reminded of their responsibilities under Standard Procedure 
II, c, 2— R, and that foremen understand the importance of withholding 
checks from employees until the required number of hours have been worked. 
Compliance with this procedure should be tested periodically by examining 
the undistributed checks of employees. 



ill. Accrued Taxes 

Sales Taxes Incorrectly Accrued— Findings 

Accrual of state sales taxes has been incorrectly handled in several respects. 

It has been the practice to accrue taxes on shipping supplies and certain 
used materials, although such materials are exempt from sales taxes. In 
January, 1951, taxes approximating $100 had been incorrectly accrued on these 
types of materials. 

In other cases, tax accruals have been erroneously omitted. For example, 
sales tax has not been accrued on billings from other company locations for 
nonproductive materials received on interplant shipping documents or for 
assessments covering stationery supplies. Also, no tax consideration has been 
given to materials billed with work order charges from other locations. It was 
found that the tax liability for the month of December, 1950, was understated 
by at least $475, principally as a result of failure to accrue taxes on materials 
used in building construction and maintenance. Inasmuch as there were 
substantial work order charges for building construction during the latter part 
of 1950, it is probable that a considerable additional tax liability exists for 
materials used for this purpose. 

Tests indicated that incorrect tax handling has been accorded certain of the 
foregoing types of transactions since January, 1950. 

If sales taxes are to be properly reported and paid, it is important that 
instructions contained in CM 72.90.26 be followed in all respects. 

Action Taken 

The plant controller issued instructions providing for centralized review 
of all interplant shipping documents, work order charges, etc., for purposes of 
accruing sales taxes. 

Recommendotions 

It is recommended that, in the future, periodic review be made of the various 
types of transactions subject to sales tax to insure that the provisions of CM 
72.90.26 are being followed in preparing monthly tax accruals. To the extent 
practicable, transactions since January, 1950, should be analyzed to determine 
the correct tax liability. Then, necessary adjustments should be recorded and 
tax reports amended accordingly. 



THE DOLPHIN MANUFACTURING COMPANY 147 

IV. Internal Control 

Need for Sirengfhening Internal Control— Findings 

Deviations from prescribed procedures and recognized principles of internal 
control and inaccuracies in the charts prepared in connection with the Com- 
pany's internal control review program were noted, as follows: 

1. Duplicate listings of cash received in the mail (Form 1064) were not 
being checked by the plant controller with entries in the cash received record. 
CM 48.20.11 provides that this verification is to be performed by the resident 
accounting executive. 

2. Custody of blank working fund checks and maintenance of the register 
for control of these checks were the responsibilities of an employee also 
engaged in processing vendors' accounts payable invoices. According to the 
internal control charts, custody and control of blank working fund checks were 
the responsibilities of the general ledger unit. 

3. The check auditing function was being performed by an employee in 
the accounts payable unit. Existing procedures require that this function be 
performed by personnel not otherwise involved in accounts payable processing. 

4. The internal control chart covering accounts receivable procedures 
showed that stock shipping orders and standard equipment sheets were being 
cleared after these documents were processed and the transactions booked. 
It was found, however, that the documents were being cleared from the 
registers when received from the shipping department and before processing 
was performed. This handling is contrary to CM 51.10.15. 

5. It has not been the practice to compare quantities shipped, as shown on 
gate release copies of stock although the internal control chart indicated that 
this function was performed. 

Action Taken 

With the exception of Item 3, the plant controller issued written instructions 
providing for correction of the above deficiencies in internal control and for 
the revision of internal control charts where necessary. 

Recommendation 

In regard to Item 3 above, it is recommended that responsibilities be 
realigned so that the check auditing function will be performed by an employee 
who is not otherwise engaged in accounts payable or disbursement functions. 

Yours very truly, 

(signed) P. L. Robey 

General Auditor 

In view of the recent changes in the organizational structure of 
The Dolphin Manufacturing Company, Mr. Robey definitely believed 
that his immediate internal audit objectives were at least threefold. 
First, it was necessary to see that the accounting regulations and 
procedures as established by the central controller's office were 



148 INTERNAL CONTROL AND INTERNAL AUDIT 

properly followed by the various company divisions and operating 
units. Second, it was important to observe that effective internal 
control was maintained in the form of appropriate organizational 
checks and balances in the company's disparate units. And, third, to 
perform its activities to most constructive advantage, the internal 
audit department had to earn wholehearted management coopera- 
tion and acceptance. Thus, once an audit report was completed, the 
question of who should do what about the deficiencies mentioned 
naturally became a management control problem of the first magni- 
tude. 

Outline a procedure which you would recommend for the audit 
follow-up of a report similar to the one presented above. To what 
extent is your suggested procedure influenced by the (a) organiza- 
tional position of the internal audit department in the Dolphin com- 
pany (that is, would it make any difference if Mr. Robey answered 
to the controller rather than to the vice-president of finance?), (b) by 
the use of the post audit, pre-report "Audit Conference" described 
by Mr. Robey, and (c) by the particular administrative problems 
arising from the Dolphin company's reorganization? 



ease 



13 



THE WESTCO OIL COMPANY 

Functional Internal Auditing Activities 

This case deals with interpretation of operating data and the pro- 
priety of action by the internal audit department. 

Until the latter part of the 1930's the internal audit department 
of the Westco Oil Company, an integrated producer, refiner, and 
national distributor of petroleum products, was concerned with such 
traditional auditing activities as vouching assets, counting cash, test- 
ing arithmetical accuracy of footings and extensions, and checking 
distributions. It was not until Mr. Henry Boynton, a capable and 
imaginative accounting executive, with refinery experience, was 
brought East and made head of this department that internal audit 
activity in the Westco company began to break away from its hum- 
drum past. 

Boynton was convinced that the internal auditing function was 
"more than treasury— it is operations." But he recognized that before 
he could accomplish his broader objectives he had to win the confi- 
dence of the company's operating personnel. Consequently he first 
picked several of the best men he could find to staff his department, 
selecting men with experience in the company's marketing, refinery, 
and transportation operations. Then he looked around for something 
that might dramatize the value of "managerial" internal auditing as 
an appraisal activity with a company-wide scope. 

Thus he spotted the fact that one refinery was billing oil to com- 
pany customers at its actual temperature of 160 degrees Fahrenheit 
without first converting to the customary 60 degrees, thereby inad- 
vertently taking advantage of temporary heat expansion. In another 
instance he was able to point out ineflficiencies in the scheduling of 
barge operations. In still another situation, Boynton's suggestion that 
the temperature of the end product be raised led to increased output 
at one of the company's refineries. 

All these suggestions were made in a friendly, constructive fashion 

149 



150 INTERNAL CONTROL AND INTERNAL AUDIT 

and it was not long before the internal audit department became 
an influential force in the Westco company organization. Although 
Henry Boynton was later promoted to a financial officership, internal 
auditing at Westco had definitely established itself as something far 
beyond routine checking. 

The latest manager of auditing, Mr. Frank Ray, was a dynamic 
individual with an actor's sense of timing who had impressed his 
own strong personality upon the Boynton tradition. As manager of 
auditing, Mr. Ray reported to the controller who in turn, along with 
the treasurer of the company, answered to Mr. Dearborn, the vice- 
president of finance. Mr. Dearborn was one of seven other vice- 
presidents who reported to the president of the Westco company. 

The headquarters staff of the Westco company's audit department 
consisted of five or six persons with approximately twenty additional 
auditors on traveling assignments between the seventy-odd company 
audit points. In keeping with the Boynton tradition, the department 
had an unlimited scope for its activities and accordingly, in the words 
of Mr. Ray, "audited operations directly." 

One of the primary objectives of the internal audit program, which 
helps to explain its effectiveness, was the training of young men of 
executive caliber, primarily for future accounting and financial po- 
sitions, such as that of treasury manager in one of the various sales 
divisions or refineries. Audit personnel were selected from within 
the company's own ranks, largely because of the desirability of hav- 
ing men who already know something about the company's operat- 
ing procedures and partly because the department's past experience 
with several auditors selected from the outside had, in general, 
proved unsatisfactory. 

Since an appointment to the internal audit staff was usually ac- 
knowledged throughout the company to constitute a major promo- 
tion, the manager of auditing could be very selective in his choice 
of personnel and he accordingly maintained a file of carefully 
screened candidates from whom he made his appointments when- 
ever a suitable opening developed. The audit staff at Westco thus 
consisted of men who had had some prior experience in the com- 
pany's treasury operations in one or more fields such as marketing, 
refinery, production, transportation, and the like. 

After perhaps three or four years of internal audit service, those 
men who had proved themselves would be promoted to other com- 
pany positions, usually in the financial or accounting areas. Those 



THE WESTCO OIL COMPANY 151 

who failed to measure up fully to expectations would, if retained in 
the company, benefit from their auditing experience wherever they 
might be assigned. In other words, the company had no "career" 
auditors. 

Every new auditor was given a preliminary training course at the 
home office where he was introduced to the top executives as well 
as to the special requirements of his new assignment. An audit 
manual had been prepared, but presumably as a guide only, for the 
auditor was expected to do his own thinking on the job. Mr. Ray 
made it his responsibility both to keep progress reports on each man 
and also to know each auditor's personal background and distinctive 
abilities so that his field assignments could be made in terms of the 
needs of both the auditor and the field audit point. 

Usually the audit was performed by a team of three, led by the 
man best qualified for the particular assignment. The audit team con- 
ducted a post audit conference at the audit point, at which signifi- 
cant findings and remedies were discussed with local management 
and visiting home oflBce officials. 

Auditors also frequently sat in at staff meetings which broadened 
their grasp of various problems at the locations audited. As Mr. Ray 
expressed it, the internal audit department was considered a door- 
way to a better job, particularly as the company subscribed whole- 
heartedly to the belief that the auditor with business "savvy" could 
save money for the company and, in the process, earn himself a 
better position. 

The home office of the Westco Oil Company, like those of many 
of the nation's leading petroleum companies, was in New York City. 
Mr. Ray's office was also here as were those of the company's top 
executives. The company, for administrative purposes, had divided 
the country into a number of sales divisions. Typical of these was 
the company's Midwestern branch, including the states of Missouri, 
Iowa, Illinois, Indiana, and Kentucky, with the divisional offices in 
St. Louis. The division manager, who answered to the vice-president 
of marketing at the New York office, was given considerable discre- 
tionary authority by the Westco company. 

In addition to the division manager, who had over-all responsibil- 
ity for the day-to-day operations and affairs of his division, there was 
a division sales manager, a manager of industrial relations, an opera- 
tions manager, and a treasury manager. Under the division sales man- 
ager one might follow the line of sales authority down through a 



152 



INTERNAL CONTROL AND INTERNAL AUDIT 



district sales manager, a sales supervisor, and to various salesmen 
who dealt directly with the independent service station operators. 

The various treasury operations, including the accounting func- 
tion, were the responsibility of the division treasury manager. It was 
to him that the chief accountant would answer, as would the division 
auditor who periodically reviewed bulk plant operations and certain 
division office transactions. The approach of Mr. Ray's auditors from 
New York was through the records at division headquarters, which 
in turn offered many leads to productive investigation in the field, 
that is, at bulk plants. These bulk plants were storage and distribu- 
tion centers, as distinguished from the company's several refineries, 
which fell under a separate major department headed by the vice- 
president in charge of manufacturing operations in New York City. 
As mentioned previously, the New York office scheduled approxi- 
mately seventy separate audit points, made up of marketing, manu- 
facturing, production, and pipe line branches throughout the 
country, all of which were visited very nearly once a year. 

The following illustrations are indicative of the kind of audit find- 
ings which Mr. Ray had in mind when he spoke of "auditing opera- 
tions directly." These illustrations are taken from three different 
audit reports, each of which covered an investigation of one of the 
company's sales divisions. The first of these examples is indicative of 
what Mr. Ray believed an imaginative audit of payrolls could 
accomplish. 

Payrolls: High overtime earnings of operating employees reported in the last 
audit have continued. Ratio of overtime to base wages for two recent years is 
shown below: 



■•^ ■ ■ ^ 


Year Ended 
April 30, 1947 


Year Ended 
April 30, 1946 




Amount 


Ratio to 
Base Wages 


Amount 


Ratio to 
Base Wages 


Base Wages 

Total Overtime 

Overtime Excluding That 
Guaranteed by Union 
Contract to Drivers 


$385,400 
131,500 

90,500 


34% 
24 


$289,000 
109,800 

81,800 


38% 
28 



Overtime was incurred principally by auto mechanics and union tank truck 
drivers in the metropolitan Los Angeles area. During the first four months of 
1947, auto mechanics averaged $106 a month overtime and union tank truck 
salesmen averaged $68 a month in excess of guaranteed overtime. 



THE WESTCO OIL COMPANY 



153 



Large overtime earnings of auto mechanics were attributed to frec^uent 
repairs necessary to keep old trucks operating. Replacements and additional 
equipment could not be obtained and more auto mechanics were not available. 

Tank truck salesmen in metropolitan Los Angeles worked long overtime hours 
in transporting gasoline from the north Los Angeles terminal because of the 
shortage in tank cars and the unavailability of union truckers. Aviation 
business which increased considerably was handled with insufficient trucks and 
personnel, and the shortage of Westco cylinders required more frequent 
delivery at out-of-schedule hours. 

As a result of high overtime, earnings of the following employees exceeded 
the salaries of their supervisors during the first four months of 1947: 



T- 7 


Classification 


Base 
Wages 


Average 
Overtime 


Earnings 


Employee 


Total 


Supervisor 


A 
B 
C 

D 


Mechanic 

Tank Truck Salesman 
Tank Truck Salesman 
Tank Truck Salesman 


$260 
310 
312 
313 


$231 
169 
156 
112 


$491 
479 
468 
425 


$431 
376 
376 
376 



Various measures to alleviate this situation ai'e being explored. 

An examination of the Credit function in the Chicago sales 
division brought to Hght the following conditions : 

Credit Violations: Need for improved credit control was evident from 
numerous extensions of credit in excess of established limits and failure to renew 
and revise terms. A similar condition was reported in the last audit. 

Balances outstanding from tank car customers exceeded established credit 
terms for fifty-one accounts. Examples are: 



Customer 


Credit 
Limit 


End-of-Month Balances 


Max. Balance 


Sept., 1947 


Aug., 1947 


Jid., 1947 


1947 


Amount 


Deere Inc. 
C. S. Cans 
C & M Mfg. 

Co. 
Myles Co. 


$50,000 
9,500 

3,000 
4,000 


$127,504 
16,699 

10,403 
8,002 


$70,788 
10,111 

4,911 
8,104 


$84,743 
8,761 

9,731 
8,629 


Sept. 31 
Aug. 21 

Sept. 30 * 
July 31 * 


$127,504 
17,562 

10,403 
8,629 



* Lacks home office approval required for balances over $5,000. 



Following are examples of expired credit authorization on larger tank car 
accounts requiring home office approval: 



Account 


Credit Limit 


Expiration Date 


Deere Inc. 


$50,000 

30,000 

6,000 


March 1 1947 


D & E Railroad 


June 15, 1947 
June 15, 1947 


Linden Can Corp 



154 



INTERNAL CONTROL AND INTERNAL AUDIT 



At September 30, 1947, sixty-two account balances represented unauthorized 
sales by G. A. Longman, Evanston, 111., distributor. These balances amounted 
to $1,010 but were protected by September, 1947, commissions payable of 
$2,305. 

Control of credit violations was further weakened by failure of the book- 
keeping section to inform the credit department of violations currently. This 
has been corrected. 

Credit terms will be reviewed and revised where justified, taking into 
consideration the harvesting season when some accounts normally become 
delinquent. Where it is impracticable to allow increased credit, payments will 
be required to hold balances within authorized limitations. The practice of 
allowing unauthorized deliveries by distributors and then making deductions 
from commissions payable, if account is not paid within a reasonable time, 
will be discontinued where practicable. Instead, distributors will be instructed 
to remit currently to Westco for unauthorized credit sales and carry customers' 
accounts on their own books. 

This last excerpt, taken from the New Orleans sales division audit 
report, suggests merely one of the possible directions in which a 
study of the Transportation function can lead. For example, 
the auditor in an earlier report on the New Orleans division made a 
study of the respective costs of renting barges as compared to out- 
right ownership. On the basis of the auditor's finding, the Westco 
company had under consideration the purchase, rather than the 
rental, of its own fleet of barges. 

Barge Movements: Control of variations on barge receipts was weak. No 
investigation or follow-up of variations over one per cent was made for several 
months even though the required monthly reports of such variances were pre- 
pared. Large differences were frequent. For example: 



Barge 


Origin 


Destination 


Date 
Unloaded 


Shore Tank 
to Shore Tank 
Loss or ( Gain ) 


Product 




Gallons 


Per Cent 




18 
39 
39 
21 
39 


Baton Rouge 
New Orleans 
New Orleans 
Natchez 
New Orleans 


Vicksburg 
Memphis 
Natchez 
Pine Bluff 
Memphis 


10/5/47 
10/30/47 
10/2/47 
8/30/47 
5/9/47 


11,335 
2,013 

(1,511) 
8,691 

(2,454) 


2.3 
4.6 

(1.8) 
3.9 

(3.0) 


Gasoline 
Gasoline 
Gasoline 
Prem. Gas 
Prem. Gas 



Barge 21 from New Orleans was unloaded at Alexandria on May 22, 1947. 
Loss on the movement appeared reasonable— 1,453 gallons or .3% of the cargo— 
but was subject to question in view of a loading loss of 5,126 gallons and an 
unloading gain of 3,171 gallons. Terminal superintendent noted on the barge 
report that barge had three leaks in the seams and gasoline was running into 



THE WESTCO OIL COMPANY 155 

the river. He suggested that the barge be repaired before reloading. Home 
office was not notified of this condition. 

Improved handling is anticipated from close scrutiny of barge reports and 
reinstatement of follow-up procedure. 

Mr. Ray continually reviewed company operations with the mem- 
bers of his staff in order to revise his audit coverage to meet such 
problems arising in the course of company activities as those illus- 
trated above. One of the problems which he had under review 
at present was whether he should instruct his auditors to make an 
analysis of budgeted as contrasted with actual marketing expense 
connected with the acquisition by the various sales divisions of new 
service station outlets. 

As is usual in the oil industry, the Westco company has several 
different contract arrangements with its numerous service station 
dealers covering the sale and distribution of Westco products. Re- 
ports on the selling cost per gallon were periodically developed by 
the accounting department on the basis of rent equivalents for each 
type station. However, Mr. Ray noted that these reports covered 
only three types of service station arrangements, designated as 
commission, three party lease, and direct lease. There was no report 
on a fourth type of dealer situation, covering newly acquired stations 
which were modernized at Westco's expense on the condition that 
the dealer convert to Westco's products. Believing that inadequate 
control might exist as a result of this omission, Mr. Ray decided to 
have his auditors make an analysis of budgeted and actual costs from 
the standpoint of economic justification for the newly acquired sta- 
tions in the Midwestern sales division. The following detailed data 
have been taken from the audit work papers filed in support of a 
final report ( see Exhibit 1 ) . 

What, if anything, do these data show? 

What action, if any, should be taken on the basis of these data? 

If you were the auditor who had compiled this information, how 
would you present your findings to Mr. Ray, the manager of 
auditing? 

How should Mr. Ray report these findings to the controller and in- 
terested vice-presidents? 

Was this investigation of newly acquired service stations, as well as 
of payrolls, credit violations, and barge shipments, properly within 
the scope of the internal audit program? 



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156 



section THREE. 



Accounting Policy 



One of the most important parts of the controller's job is to 
develop the accounting policy required to provide management with 
the information it must have, if it is to function satisfactorily. At the same 
time the policy must comply with the standards developed by the 
accounting profession and the requirements imposed by various regu- 
latory and tax collecting agencies. Cases in this section raise, among 
others, such major accounting questions as inventory valuation, depreci- 
ation policy, and the effects of price level changes on financial reporting 
to management, stockholders, and interested parties outside the business 
enterprise. 

16. Consolidated Leather Company 

17. Balford Automotive Parts, Incorporated 

18. Terrini Construction Company 

19. Shipstead Electronics Corporation 

20. Bighorn Drilling Company 

21. The Reece Corporation 

22. The Pan American Company 



157 



case lO 

CONSOLIDATED LEATHER COMPANY 

Selection of Method of Inventory Valuation (LIFO) 

This case is concerned with the deliberations of the management of 
a leather processing company in making a decision as to whether to 
adopt the last-in, first-out method of inventory valuation. 

The management of Consolidated Leather Company was review- 
ing, early in 1953, the company's current policies in the area of in- 
ventory accounting. For many years the management had been 
concerned about the effects, on the company's reported earnings, 
of what it termed "inventory gains and losses." In almost every an- 
nual report to the stockholders since 1929, the president had called 
attention to the presence of this problem. The following quotations 
from the annual report for 1949 give some indication as to why the 
company's operations were subject to such inventory gains and 
losses : 

Because of the long transportation period on imported raw materials, and the 
long tanning process itself, more than six months elapse from the time Con- 
solidated buys raw goatskins in foreign markets until it sells the tanned kid 
leather. The company therefore always has a large inventory of raw, semi- 
finished, and finished skins, and net earnings are appreciably affected by 
changes in inventory value. 



As has been explained, changes in the value of the company's necessarily 
large inventory exert an important effect on earnings, and a price decline of 
sufficient severity can turn an operating profit into a net loss. Despite the price 
gyrations of the past twenty years, the company operated profitably each year 
except for losses in three years resulting from declines in inventory prices. 

Consolidated Leather Company was engaged in the processing of 
raw skins and hides into finished leather stock. The concern proc- 
essed some seven to nine million skins and hides annually, about 80% 
or 90% of which were goat- and kidskins; the remaining 10% to 
20% consisted of various classes of cow- and horsehides.^ The com- 

1 During recent years, the non-goat and non-kid volume had accounted for an in- 
creasingly greater share of the total. 

158 



CONSOLIDATED LEATHER COMPANY 159 

pany's annual volume of goat- and kidskins constituted approxi- 
mately 25% of the total number of such skins processed each year 
in the United States. 

The company specialized in producing leathers for manufacturers 
of ladies' shoes and handbags, and over 75% of the concern's sales 
were made to that group. The remainder went to producers of mis- 
cellaneous leather goods primarily for upper leathers for men's shoes, 
in both domestic and export markets. 

Consolidated Leather Company's operating organization consisted 
of four tanneries and five trading divisions which were set up pri- 
marily on a product basis. These divisions, and the types of leather 
sold by each, were as follows : " 

1. Standard Division— Black and Colored Suede and Colored 
Glazed Kid. 

2. Centerville Division— Colored Glazed Kid and Crushed Kid. 

3. Oyster Bay Division— Black Glazed Kid. 

4. McLean Division— Colored Glazed Kid (primarily browns and 
blues ) . 

5. Braintree Division— Novelty Kid, Patent Kid, Slipper Colt, and 
Patent Side Leathers. 

For merchandising purposes the management classified finished 
leather stock into two broad groups which were designated as ( 1 ) 
"style" merchandise and (2) "staple" merchandise. The first cate- 
gory consisted of all the items for which the demand was markedly 
influenced by the factor of style. In this group were all of the 
"colored" glazes (including blacks and conservative browns and 
blues ) , the novelty leathers, the patent kid, and most of the colored 
suedes. The "staple" group consisted of the black and conservative 
brown and blue glazed kids, the patent side leather, the slipper colt, 
all the black suedes and a few of the more conservative colored 



~ Glazed kid is processed from the exterior or grain side of the goat- or kidskin; its 
name is derived from its very smooth surface. Suede is a very soft finish produced by 
processing the flesh side of the skin. Novelty kids inchide very fancy finishes such as 
a 24 kt. gold lace superimposed on a colored, glazed, or suede kid (these novelty 
finishes are used primarily for ladies' party shoes and handbags). Patent leather is 
also processed from the exterior side of the skin or hide; it has a lacquer or varnish 
finish which bears a brilliant polish. Slipper Colt is a leather processed from the hides 
of colts and used primarily for house slippers. Side leather is processed from cowhide 
or calfskin. Crushed kid is a soft finish processed from the exterior of the goat or 
kidskin. 



160 ACCOUNTING POLICY 

suedes. The company's sales had for many years been so concen- 
trated in the colored leathers of the "style" group that, throughout 
the leather industry, it had established a reputation of being a "color 
house." 

The cowhides and colt hides, from which the company processed 
side leather and slipper colt leather, came from both domestic and 
foreign sources. The goatskins and kidskins, however, were all im- 
ported. The principal geographical areas which in the past had 
provided the goatskins and kidskins were India, Pakistan, China, 
North Africa, the East Indies, Spain, the Balkan countries, and 
Brazil. In recent years, however, imports from China and the Balkan 
countries had sharply declined because of difficulties imposed by the 
extensive political changes taking place in those areas. 

As already stated, one of the chief problems confronting the 
management of Consolidated Leather Company was the control of 
its large investment in inventories, and the interpretation and re- 
porting of operating profit to give proper reflection to inventory 
price changes. The significance of this item to management can be 
judged from the fact that inventories usually amounted to from 
one-third to one-half of the dollar value of the company's total assets. 
A variety of factors contributed either directly or indirectly to the 
company's large inventory requirements. 

Perhaps the greatest single factor influencing the amount of the 
company's inventories was the length of its supply "pipeline," or, in 
other words, the time that expired between the date raw skins were 
contracted for and the time when finished leather stock could be 
shipped to the company's customers. Four months usually passed 
from the time raw skins were purchased in the foreign markets until 
they were available in the company's tanneries. An additional six 
weeks to two months were required for processing and delivering 
the finished leather to the selling divisions. Since the selling divisions 
normally carried inventories equivalent to about one month's sales, 
the company's complete supply "pipeline" was typically six to seven 
months long. 

In order for Consolidated's customers to convert finished leather 
into shoes, handbags, and other consumer products and make suffi- 
cient deliveries to insure that their retail outlets were fully stocked 
at the beginning of any particular consumer buying season, the 



CONSOLIDATED LEATHER COMPANY 161 

finished leather had to be available in their factories at least four to 
six months prior to the opening of a season. The total elapsed time, 
then, between the contracting for raw skins and the sale of shoes, 
handbags, etc., to the final consumer, was about ten to twelve 
months. It was necessary therefore, that the company's buyers be 
able to anticipate, as much as a year in advance, the types and colors 
of leather that would be the fashion in a particular season. Its policy 
of concentrating in leathers for highly styled merchandise made 
this buying problem particularly difficult for Consolidated Leather 
Company. 

Although a large percentage of raw skins purchased could be used 
for several different types and colors of finished leather, there were 
skins of certain qualities, or from certain geographical areas, which 
were more suitable to particular finishes or colors of leather stock. 
Suede, for instance, was normally processed from a different type of 
skin from that suitable for a glazed finish of a light color. When hides 
purchased specifically for processing to one particular finish were 
diverted to another type of finish to meet a shift in consumer de- 
mand, such diversion usually resulted in higher costs for the finished 
leather stock. For example, if a particular type of skin, purchased 
for a certain finish, was used for a leather which could have been 
processed more easily from a different type of skin, increased tan- 
ning costs were incurred, and the company was placed at a cost 
disadvantage for its finished leather, unless, of course, most of its 
competitors had found it necessary to make similar reroutings of 
raw materials. It was the company's policy therefore to buy sufficient 
quantities of skins of various qualities and characteristics to avoid, 
as far as possible, the added costs of diverting raw materials. This 
policy was, in effect, a second factor contributing to the company's 
large inventory investment. 

A third factor which greatly influenced the company's buying 
policies and tended to increase the size of its inventories was the 
lack of stability in the supply of raw skins in the import markets. 
The markets sometimes ran the gamut from being completely "dried- 
up" to being thoroughly saturated within a period of a few months 
without any satisfactory degree of predictability as to which of these 
extreme conditions might be expected next. To reduce the chances 
of being caught short on raw skins, the company made it a practice 



162 ACCOUNTING POLICY 

to assure itself of the necessary quantities by building up stocks in 
periods when the supply was plentiful. 

Another raw material factor had a marked influence on the com- 
pany's procurement and inventory policies. This element, the sharply 
fluctuating prices of imported goatskins and kidskins, tended to exert 
an opposite influence on the size of the inventories, however. The 
following example serves to illustrate the difficulty of trying to cope 
with this factor. Skins which the market quoted at $18 to $20 per 
dozen in January of 1951 were quoted in March, 1952, at about 
$4.50. By the end of 1952, however, the prices of these same skins 
had recovered to around 50% of their 1951 peaks. To minimize 
losses due to these fluctuations, the management's policy in this 
respect was to buy as conservatively as it possibly could and still be 
assured of the necessary quantities of raw materials to meet its needs. 
Since periods of good supply of raw material did not necessarily 
mean that the prices were especially low, there was often a conflict 
between the company's policies for dealing with the two factors of 
market supply and market price, with the result that the manage- 
ment was continually striving to maintain a delicate balance between 
running into raw material shortages, on the one hand, and what Mr. 
Fred Jamison, the controller, referred to as "losing our shirts," on 
the other. 

Mr. Jamison emphasized that the company's "over-all manage- 
ment policy" was "to make its profit by eflicient manufacturing and 
vigorous selling and not by 'gambling' on inventory gains or losses." 
But the complications involved in maintaining inventories at opti- 
mum levels had made it practically impossible for the company to 
eliminate completely the element of "gambling." For many years, 
therefore, one of the management's chief concerns had been the 
effects of inventory gains and losses on the company's reported 
profits. 

In each of the years 1929, 1930, 1931, 1934, 1937 and 1938, the 
president had commented in the company's annual report to stock- 
holders on the "substantial" or "marked" write-offs of inventories 
made necessary by sharp breaks in raw skin prices, while in the an- 
nual report for 1933 he called to the attention of the company's 
stockholders that "a substantial portion of the profits [for the year] 
is attributable to the rising market which has existed since the early 



CONSOLIDATED LEATHER COMPANY 163 

part of 1933." The importance that the company's management at- 
tached to the problem of inventory gains and losses can be seen 
from the following quotation from the president's comments in the 
annual report for 1935: 

Unless there should be monetary adjustments by those countries now on the 
gold basis, there is but little likelihood of any substantial loss in our raw 
material inventory which is generally the most serious problem with which we 
have to contend. 

As a step in the direction of minimizing the effects of inventory 
gains and losses on earnings reported to stockholders and for tax 
purposes, the board of directors decided to adopt, beginning with 
the fiscal year ended June 30, 1940, the last-in, first-out (LIFO) 
method for valuing the company's inventories. This decision fol- 
lowed the authorization, by the Revenue Act of 1938, of the LIFO 
method for federal income tax purposes. The 1938 act authorized 
the use of the LIFO method in filing tax returns provided that the 
taxpayer: 

1. Files the required form with his tax return for the first year in 
which LIFO is to be used, indicating an irrevocable election of 
the LIFO method; 

2. Carries his inventories at cost {not the "lower of cost or mar- 
ket") while he is on LIFO; 

3. Recomputes the closing inventories of the year preceding the 
change to LIFO on a cost basis; 

4. Uses the LIFO method in his other financial statements, e.g., 
stockholder reports, for the year in which LIFO is elected and 
for all succeeding years; and 

5. Agrees to such adjustments in the application of the method 
as the commissioner may deem necessary to reflect income 
clearly. 

In order to comply with requirement ( 4 ) above, the company used 
the LIFO method of inventory valuation in the preparation of its 
semiannual report to stockholders as of December 30, 1939. Although 
the primary reason for the adoption of LIFO at this time, as ex- 
plained by the controller, was the apparent tax savings which would 
accrue to the company as a result of the change, the president, in 
the following excerpt from the December 30, 1939, semiannual re- 



164 ACCOUNTING POLICY 

port, pointed out other benefits the company expected to gain from 
the use of the method: 

This method should result in steadier earnings in the future, without extraor- 
dinary peaks and valleys. It should avoid the possibility of earnings based upon 
inflated values which are rarely realized and will lessen the likelihood of sub- 
stantial losses in the future since the inventory was valued on a comparatively 
low level. 

By the close of the company's fiscal year ending June 30, 1940, 
however, goatskin prices had dropped so sharply that the inventory 
value under the LIFO method was considerably above what it would 
have been under the conventional "lower of cost or market" method 
which had been used by the company in prior years. Since the ir- 
revocable step ( see requirement ( 1 ) above ) of filing the tax returns 
under the LIFO method had not yet been taken, the directors de- 
cided to postpone the adoption of the new method until a more 
suitable time. 

For its fiscal year ending June 30, 1941, Consolidated Leather 
Company showed a very favorable profit figure. But the manage- 
ment, as it had in connection with the profit for 1933, attributed a 
good share of the 1941 profit to "inventory gains." To avoid report- 
ing any such inventory gains in the company's financial statements 
for the following fiscal year, the president, in the semiannual report 
as of December 30, 1941, announced that the company would adopt 
the LIFO method of inventory valuation for the fiscal year 1942. 

In the company's annual report for the fiscal year ending on June 
30, 1942, however, the president made the following statement. 

Price ceilings on leather, together with reduced demand for goatskins due to 
government restriction of production, have caused a drop in goatskin values to a 
point somewhat below the valuation on the "last-in, first-out" principle. We 
have therefore found it desirable to value our goatskins inventory on the basis 
of the lower of cost or market and to abandon the last-in, first-out method used 
on our semiannual report. 

Accordingly, the company did not file its tax returns for the fiscal 
year 1942 on the LIFO basis. 

Because of wartime shortages of raw materials from 1942 through 
1945, the physical quantities of the company's finished leather in- 
ventories decreased considerably. The management recognized by 
1943 that, since both raw material and labor prices were likely to be 
generally higher during that period of inventory liquidation than 



CONSOLIDATED LEATHER COMPANY 165 

they had been during the period just prior to 1942 ( when the inven- 
tory was being accumulated ) , the company's reported profits would 
probably reflect a gain on the liquidation of these inventories. It 
also recognized the likelihood that the finished leather inventories 
would have to be replaced, when the shortage of raw skins became 
less acute, at somewhat higher raw material and labor costs than 
those represented in the inventories liquidated. The management 
therefore, in anticipation of these developments, reserved out of 
profits during those three years ( 1943, 1944, and 1945 ) an amount 
sufficient to cover the higher costs of replacing the inventories. Then, 
during each of the years 1946, 1947, and 1948, as finished leather 
inventories were replaced, it became necessary to transfer amounts 
from this reserve to the profit for the year to offset the effects of the 
higher costs of replacing the liquidated inventories. The manage- 
ment felt that the necessity for making these transfers "proved the 
wisdom of our having established the reserve in the earlier war 
years." 

The removal in 1946 of price controls and other government 
restrictions on the purchase of raw skins and hides was followed by 
marked increases in the prices of both the company's raw materials 
and its finished leather. Commenting on this development in the 
annual report for the fiscal year ended June 30, 1947, the president 
made the following statement: 

Our sales were on the replacement basis ^ and a large part of these sales were 
from goods purchased before the price rise, thus resulting in abnormal profits. 
These profits are likely to be offset in part by inventory losses when the price 
trend reverses itself and it is for this reason that we set up on December 31, 
1946, the "Reserve for Possible Future Price Declines on Raw Skins and Hides." 

The purpose of this reserve, as explained in the company's notes to 
its financial statements in the 1947 annual report, was to deduct 
from profits for the year an amount sufficient to "reduce the inven- 

3 Mr. Jamison, explaining the meaning of the term "replacement basis" used by the 
president in this quotation from the annual report for 1947, said that the company, in 
setting its prices, recomputed the cost of goods sold so that all raw materials included 
in the merchandise sold were valued at approximately the prices prevailing at the 
time the merchandise was sold. He stated that the prices used only approximated 
actual replacement prices because the recomputation was made as of the time the 
finished leather was transferred from the tanneries to the selling divisions. Since these 
divisions normally carried about a month's supply of finished stock, the actxial replace- 
ment prices at the time of sale might be slightly different from those at which the in- 
ventory transfers were made. 



166 ACCOUNTING POLICY 

tory at June 30, 1947, to approximate last-in, first-out basis." This 
practice was continued through June 30, 1950. The company did not, 
however, adopt the LIFO method for tax purposes during that 
period. 

For the fiscal year ended June 30, 1951, the directors of Consoli- 
dated Leather Company, believing that raw material prices were as 
low as they could be reasonably expected to fall, in view of the price 
levels of other commodities, again decided to adopt the LIFO 
method for federal income tax purposes. Exhibit 1 represents the 
company's efforts to explain to its stockholders the implications of this 
move and its immediate effect on the year's profits and on certain 
balance sheet items. 

By early 1952, however, the raw material market had again broken 
sharply, and the board of directors once more reversed its decision 
to adopt LIFO for tax purposes. In this connection, the president, in 
April, 1952, wrote the following letter to the company's stockholders: 

To THE Stockholders of Consolidated Leather Company: 
Change in Inventory Mefbod: ^ 

In reporting to you the operating results for the fiscal year ended June 30, 
1951, and the six months ended December 31, 1951, the company used the 
LIFO (last-in, first-out) method of valuing part of its inventories. As explained 
in the Annual Report, this valuation was equivalent to the cost of the skins and 
hides we owned on June 30, 1950. 

When it was decided to use LIFO, it was thought that the base prices- 
cost at June 30, 1950— were reasonably low in view of the value of the dollar 
and of the price levels for other commodities. This proved to be wrong. On 
December 31, 1951, as stated in the "Inventory Note" on the Semiannual Re- 
port, the LIFO inventory was $350,000 above the prevailing market. Since 
December 31, there have been further declines, so that if the company had 
continued to value its inventories on the LIFO basis the inventories would have 
been considerably overstated and the profits correspondingly distorted. 

Ordinarily, the LIFO method of inventorying, once established for tax pur- 
poses, cannot readily be changed. However, because of special circumstances 
resulting from the retroactive changes in the tax laws for the calendar year 1951, 
the due date for the filing of the final tax return for the fiscal year was ex- 
tended to March 15, 1952. Therefore, according to the company's understand- 
ing of the tax laws, it is permissible to abandon LIFO and resume the former 
method of pricing inventories. Amended tax returns have now been filed with 
inventories stated at the lower of cost or market. 

Attached hereto is a memorandum (Exhibit 2) showing the operating results 
for the year and for six months as originally reported on the LIFO method and 
as restated on the former method of inventory valuations. As in the past, adjust- 
ments have been made in the Inventory Reserve which result in stating the 
profits on a replacement basis. 



CONSOLIDATED LEATHER COMPANY ^61 

In its annual report for the fiscal year ended June 30, 1952, the 
company therefore announced that it had reverted to its practice, 
started in 1947, of establishing a reserve to "reduce the inventories 
of skins and hides to an approximate last-in, first-out basis (as of 
June 30, 1946) without adopting this principle for federal income 
tax purposes." 

The controller emphasized the fact that the company's "in and 
out" approach to statutory LIFO was strictly a reflection of efforts 
to minimize tax payments to the extent feasible. He pointed out that 
for the concern's "over-all management policy," it had since 1947 
followed methods which approximated LIFO. He felt that some 
method similar to LIFO was absolutely necessary if the company 
was to adhere to its professed philosophy of conservatism in profit 
reporting. The controller reiterated that the company's "top man- 
agement" policy was "to earn its profits by efficient manufacturing 
and vigorous selling and not from 'gambling' on inventories." He 
thought that if "purely inventory profits" were allowed to appear in 
the company's reported earnings, the stockholders were not being 
given a true picture of the "real profits resulting from operations." 
He stated that the company's past experience had adequately proved 
that such inventory gains were only temporary and would be offset 
by inventory losses later when prices began a downward movement. 

Mr. Jamison also pointed out that the board of directors and man- 
agement of the company wanted the prices of the company's stock, 
as quoted on the New York Stock Exchange, to reflect the stability 
of the company's earnings from operations and a steady dividend 
policy. He said that Consolidated was generally known as the "best 
leather stock" on the market and that the board was eager for the 
company to maintain that reputation. He did not believe the com- 
pany's stock would be so highly regarded if reported earnings were 
made a function of raw material prices, as he thought would neces- 
sarily be the case unless some attempt were made to match "current 
costs with current revenues. " 

The controller pointed out, however, that his company's attempts 
to establish a basis for steadier earnings and dividends had created 
some minor problems in stockholder relations. He said, for example, 
that one very small shareholder had taken exception to the deduc- 
tion in the statement of profit and loss in the company's 1947 annual 
report of the $550,000 labeled "Transfer to Reserve for Possible 



168 ACCOUNTING POLICY 

Future Price Declines on Raw Skins and Hides." This particular 
stockholder was primarily interested in immediate cash dividends 
and interpreted the creation of the "Reserve for Future Price De- 
clines" as merely an effort by management to keep down the net 
profit figure and, consequently, the company's dividend payment 
for the year. Mr. Jamison said that although the problem had been 
relatively minor in his company's case, the management had never- 
theless felt obliged to review in some detail, in the 1948 annual re- 
port, its history of earnings and dividends over a number of years. 

Mr. Jamison made it clear that for "management considerations 
other than those pertaining to taxes," he preferred the "replacement 
method" to LIFO. He explained that the chief difference he saw 
between the two concepts was that the LIFO method costed mer- 
chandise sold as if the units sold were the ones most recently pur- 
chased, whereas the "replacement method" valued goods sold at 
prices prevailing at the time of the sale. He thought, however, that 
the LIFO method provided such a close approximation to "replace- 
ment cost" that, where substantial tax savings were at stake, the tax 
factor might become overriding and tip the balance in favor of 
LIFO. 

The controller said that one of the big disadvantages he saw in 
the LIFO method, from the point of view of company management, 
was that it made it difficult to compare the company's operating 
results with those of other companies in the industry. This difficulty, 
he explained, existed even in comparisons with companies using the 
LIFO method because of various dates on which different com- 
panies had adopted LIFO, or because of other differences in their 
LIFO inventory bases (for example, physical quantities included, 
and the like ) . He also thought that members of the investing public, 
whether they realized it or not, were faced with the same problem 
in trying to use reported earnings as a basis for appraising the merits 
of the stock of a LIFO company as a potential investment. 

Mr. Jamison pointed out as a second disadvantage of LIFO the 
discrepancies that the method frequently produced between "in- 
terim" financial statements and those prepared to cover operations 
for the entire year. He explained that this difficulty arose from the 
fact that LIFO inventory quantities were sometimes partially liqui- 
dated early in the year and not replaced as of the "interim" date. 
Such liquidation, in any period where selling prices of finished goods 



CONSOLIDATED LEATHER COMPANY 169 

were based on raw material prices higher than those in the LIFO 
base, caused "interim" income statements to reflect "inventory gains." 
By the end of the year, however, LIFO inventory quantities would 
have been replaced and, therefore, the income statement for the 
entire year would not reflect the inventory gains which had appeared 
in the "interim" statements. Mr. Jamison said that in his company, 
where semiannual statements were prepared for both management 
and stockholders, it was sometimes difficult to explain why opera- 
tions for the last half of the year were less profitable than might 
have been expected, judging from the earnings shown in the first 
six months of the year. 

A third disadvantage which Mr. Jamison saw in the LIFO method 
was the danger that the tax factor, because of the immediate savings 
it would sometimes offer, might be allowed to overshadow other less 
obvious management considerations. He felt that if his own com- 
pany were using LIFO for tax purposes, there might very well be 
times when the management would be sorely tempted to replace 
liquidated LIFO inventory quantities simply to avoid paying taxes 
on the gains from such inventory liquidation, when actually other 
considerations, such as market conditions, might indicate that the 
best course open to the company would be to pay the tax on the 
gains and maintain the inventory at the lower level. He thought that, 
whereas the nontax considerations would not be completely ignored 
by most managements, there would undoubtedly be times when the 
tax factor, because of its immediate dollar implications, would tend 
to receive more than its proportionate weight. 

Mr. Jamison said that it was possible that Consolidated Leather 
Company had missed, perhaps early in the 1940's when finished 
leather and goatskin prices were relatively low (see Exhibits 3 and 
4), its best opportunity to adopt the LIFO method for tax purposes. 
He did not think, however, that there was any way of determining 
how much better the company would have fared if it had adopted 
LIFO in the early forties. He pointed out that it would not be too 
difficult to approximate the difference between the company's actual 
profits and those that would have resulted under LIFO, if one ac- 
cepted the inventory facts as they actually existed, but he empha- 
sized that there was no way of knowing what differences would have 
appeared in the inventory figures if the tax factor had been present 
to exert its influence upon the company's buying and selling policies. 



170 ACCOUNTING POLICY 

The controller said that the management of Consolidated Leather 
Company still had an "open mind" on the proposition of adopting 
the LIFO method of inventory valuation for tax purposes, and that, 
as the 1951 and future fiscal year-ends approached, the question 
would no doubt again be given careful consideration and thorough 
discussion. 

( EXHIBIT 1 

- Notes Regarding LIFO Inventory and the Effects of LIFO 

on the Results for the Year Ended June 30, 1951 

The balance sheet as of June 30, 1951, and the profit for the fiscal year 
have been stated on the LIFO (last-in, first-out) method of inventory for all our 
raw materials and for the raw material content of our finished leather. Without 
attempting to go into the technical details of the LIFO principle, it may be 
well to explain that this method permits an inventory value at the average cost 
of the materials in the inventory at the beginning of the first year when the 
LIFO method is used. In our case this means that the inventory as of June 30, 
1951, is valued at average costs on June 30, 1950, for our raw materials and 
the raw material content of our finished leather. Moreover, for inventory 
quantities equal to the quantities on hand July 1, 1950, we shall be permitted 
to use the same value for our inventories at the close of each fiscal year in the 
future, regardless of either the cost or market value. 

The effect of LIFO for the fiscal year is as follows: 

A. INVENTORY RESERVES 

1. It will no longer be necessary to use Inventory Reserve adjustments in 
order to state our profits on replacement. 

2. The amount of $175,000 added to the Inventory Reserve on December 
31, 1950, as shown on our semiannual statement, is now eliminated. 

3. The Inventory Allowance of $650,000 as of June 30, 1950, will remain 
on our books as a reserve in the event that raw skin prices should at 
some future date drop below the present LIFO costs. 

B. RAW MATERIALS 

The LIFO inventory of raw skins and hides is valued at about $400,000 
below the market on June 30, 1951. 

C. FINISHED LEATHER 

Since our leather inventories consist of numerous colors, finishes, and 
grades, these inventories have been valued in the past below cost in 
order to allow for losses which might result from changes in demand 
and style factors. Under the LIFO inventory method, the value of our 
leathers is approximately $338,000 greater than under our old method. 
It must be remembered, however, that under the LIFO principle the 
inventory is still conservatively valued. 



I 



CONSOLIDATED LEATHER COMPANY 171 

D. EFFECT ON PROFITS 

If our inventories had been valued under the same principle as in prior 
years, but without any adjustment of the Inventory Reserve, the profit 
after taxes would have been $895,324 as against $901,160 on the LIFO 
base. The more favorable results under LIFO for the current year 
arise because, under LIFO, part of the profits for this fiscal year are 
taxable at the lower rates prevailing in the prior year. 

Note A to the Financial Statement: 

In the pricing of the inventories of raw skins and hides and the raw skins 
and hides content of in-process and finished leather ($4,396,594.89), the 
company has adopted the last-in, first-out method of determining cost 
instead of the method previously used. Such change had the effect of re- 
ducing the amounts stated for inventories at June 30, 1951, by $71,000; 
however, the net profit for the year was increased by approximately 
$6,000 because of adjustments to a LIFO basis in the opening inventories 
which are taxable at the lower rates in effect for the previous fiscal year. 
Other inventories ($1,359,167.99) were priced at the lower of first-in, 
first-out of cost or market, less allowance for possible losses due to style 
changes. The allowance of $650,000 provided in prior years to reduce the 
inventories of raw skins and hides to an approximately last-in, first-out 
basis had been retained in the event prices decline below the LIFO base. 



172 



ACCOUNTING POLICY 



EXHIBIT 2 

Summary of Operations 





Year Ended June 30, 1951 


Six Months 
Ended December 31, 1951 


^' 


Originally 

Reported on 

UFO Method 


Restated on 
Method Used 

Prior to 
June 30, 1951 


Originally 

Reported on 

LIFO Method 


Restated on 
Method Used 

Prior to 
June 30, 1951 


Total gross income 

Cost of products sold 
Other expenses 


$20,091,525 

16,665,294 
1,835,071 

18,500,365 


$20,091,525 

16,259,865 
1,835,071 


$8,132,875 

7,087,672 

778,270 


$8,132,785 

7,889,182 

778,270 


Total costs and expenses 


18,094,936 

1,996,589 

225,000 


7,865,942 
266,843 


8,667,452 


Profit before reserve and 
taxes 

Reserve for inventory- 
increased 

Reserve for inventory- 
decreased 


1,591,160 


534,667* 
525,000 


Profit after reserve, 
before taxes 

Provision for federal taxes 

Federal tax refundable 


1,591,160 
690,000 


1,771,589 
900,000 


266,843 
135,000 

— 


9,667* 
250,000 


Net profit after reserve 
and taxes 


$ 901,160 


$ 871,589 


$ 131,843 


$ 240,333 



Loss 



Status of Inventory Reserve 

( Allowance for Possible Price Declines of Raw Skins and Hides ) 

June 30, 1951 

Balance per Balance Sheet as originally reported .... $650,000 

Reserve increased, as above 225,000 

Adjusted balance 875,000 

December 31, 1951 

Reserve decreased, as above 525,000 

Adjusted balance $350,000 



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174 



ease 1 T 

BALFORD AUTOMOTIVE PARTS, INCORPORATED 

Procedures for the Control of Fixed Asset Additions 

In this case, the ever-present problem of applying accounting prin- 
ciples and manuals to specific problems is presented. The issue is 
one of determining what expenses are to be capitalized under the 
provisions of a company's accounting manual. 

The Balford Automotive Parts Company was a large producer of 
automobile castings and small metal parts for the automobile in- 
dustry. The company was reasonably large with annual sales of 
$50,000,000, and it employed about 3,400 productive personnel. Bal- 
ford maintained its home offices in Detroit. Branch offices were 
located in Saginaw, Flint, and Pontiac, Michigan. The company also 
owned a number of subsidiary companies located in Linden, New 
Jersey; Somerville, Massachusetts; Sacramento, California; and St. 
Paul, Minnesota. Branches and subsidiaries were given about the 
same status, both commonly referred to as "divisions." 

Each division of the company was headed by a vice-president who 
reported directly to Balford's president in Detroit. The division 
head's staff included a sales manager, a production manager, and a 
controller, all of whom, while directly responsible to the division 
head, also had a functional relationship with their counterparts on 
the president's management staff in Detroit. The company's man- 
agement believed that this relationship was valuable for communi- 
cating information and suggestions among its various divisions. In 
fact, major policies set by top management were transmitted through 
the staff organization as well as through the operating line to divi- 
sion heads. 

Although the controller at division level was responsible to the 
division head, there were certain procedures and standards estab- 
lished by the Central Controller's office with which he was expected 
to comply. An example of such procedures was one designed to re- 
tain in the central offices in Detroit a high degree of control over the 
expenditure of funds for fixed assets. 

175 



176 ACCOUNTING POLICY 

There were a number of reasons why Balford insisted on retaining 
in its central offices close control over the company's fixed assets. 
One reason was that the firm's fixed assets, which amounted to about 
$18,000,000, represented a large portion of its total investment. 
Secondly, the company's success depended to a very great extent 
upon its remaining well abreast of technological progress in the 
automotive industry; the company's executives believed that its re- 
equipment policy was an integral part of the management and con- 
trol of fixed assets. Thirdly, the concentration of control over fixed 
assets in the central office made it possible for Balford to develop a 
group of experts each of whom had a highly specialized knowledge 
of a particular type of equipment used by the company. Also, the 
management believed that the internal audit of its fixed assets would 
be greatly facilitated by the concentration of control at the central 
office level. Finally, it was generally believed that the central con- 
trol provided greater assurance that the company maintained ade- 
quate insurance coverage for its fixed assets. 

Depreciation Policy 

In accordance with the policy of centralization of the control of 
fixed assets, matters concerning fixed asset depreciation came within 
the purview of the company's home office in Detroit. Although the 
division responsible for the purchase of a new asset might suggest 
a depreciation rate, the final determination of depreciation rates was 
established by the central office, and each year the central office 
re-examined established rates to determine whether they were still 
adequate, taking into account any developments which may have 
served to alter the bases upon which the rates were originally estab- 
lished. The factors listed by the company as being relevant to the 
question of depreciation rates were : 

A. Allowable tax rates 

B. Estimated life, determined by: 

1. the manufacturer 

2. the plant engineering staff 

3. the central office manufacturing staff 

4. outside consultants 

C. Use of the asset 



BALFORD AUTOMOTIVE PARTS, INC. Ml 

D. Price of the asset 

E. Fragility of the asset 

F. Accountabihty of the asset 

G. Obsolescence factors (technological) 
H. Experience of other manufacturers 

Acquisitions 

Although requests for fixed asset acquisitions typically originated 
at division level, and the details to support the request developed 
there, the final disposition of such requests was in the hands of the 
home office. Upon completion of an acquisition, the division office 
recommended to the home office a distribution of the costs and 
expenses incurred in connection with the purchase and, as stated 
earlier, suggested a depreciation rate. Such matters were of consid- 
erable interest to the division head because of their effects upon the 
division profit and loss statement which provided the primary basis 
for judging the performance of division managers. In order to 
achieve as much consistency as possible among difi^erent divisions 
and different projects, with respect to the disposition of expendi- 
tures and the establishment of depreciation rates, the central office 
also maintained close supervision over these matters. 

Exhibit 5 presents some excerpts from Balford's procedures 
manual on fixed assets. 

The project described below is a typical example of the kinds of 
projects for which capital expenditures were made. 

In August, 1956, the executives of Balford decided to restore the 
structural integrity of three Detroit buildings: a utility building, its 
annex, and "A" storehouse, and to preserve and improve the appear- 
ance of these structures by the application of waterproofing ma- 
terials, cleaning and repairing the concrete, establishing a newer 
and better drainage unit, and painting the steelwork. The project 
was completed in November, 1956, at a cost of $36,476.50. Exhibit 1 
gives the detailed breakdown of these costs. 

This project, similar to many other such projects, was the first of 
its specific type— restoration of concrete buildings— since the war. 
In order to acquaint the executives fully with what was being done, 
Balford prepared the following memorandum. 



178 ACCOUNTING POLICY 

EXECUTIVE MEMORANDUM 
Purpose 

Utility Building— The reinforced concrete pilasters and spandrel beams of 
this structure are in very poor condition; concrete has deteriorated and spalled 
off to such an extent that the main steel is exposed. The individual brick 
and terra-cotta sections are structurally sound, but the mortar joints have 
deteriorated, have eroded considerably, and are not watertight. The acceler- 
ated deterioration of this structure must be checked at once; otherwise, major 
reconstruction of the exposed north and west elevations will be necessary. 
Photographs showing the condition of this structure are appended. 

Utility Building Annex— This brick and concrete structure is in good condi- 
tion structurally. Deterioration is commencing, and restoration and water- 
proofing are necessary to arrest the decay of the structure before the deteriora- 
tion becomes accelerated. The poor appearance of this structure in contrast 
to a clean utility building would be so "marked" that it would be highly 
desirable to clean, restore, and waterproof this structure along with the Utihty 
Building proper. Establish drainage system. 

"A" Storehouse— The reinforced concrete exposed to the weather has begun 
to deteriorate at an accelerated rate. Water has entered the concrete, corrod- 
ing the steel, and the rust has caused the concrete to spall off. Many small 
cracks are appearing, and it is necessary that the concrete be repaired and 
waterproofed to retard this deterioration. 

The metal sash and doors and steel water tanks and supports are beginning 
to show rust spots. Complete cleaning and repainting are necessary. 

Description 

Concrete— Cut out loose, deteriorated concrete to good, sound live material, 
clean reinforcing steel, add reinforcing steel where necessary, and repair 
concrete by patching or uniting in an acceptable manner, with nonshrink 
concrete. Clean all surfaces thoroughly by wirebrushing or sandblasting, and 
waterproof to exclude entrance of water. Concrete windows and door sills 
are to be repaired in a like manner. 

Brick and Terra Cotta— Clean the exposed areas thoroughly by wirebrushing, 
sandblasting, or any other method required to remove all foreign materials; 
rake out deteriorated mortar joints and repoint; replace broken brick or stone, 
and waterproof to exclude entrance of moisture. The back of pai'apet walls 
are to be treated in a like manner. 

Doors, Windows, and Metal Wor/c— Clean thoroughly to remove all rust, and 
paint with one coat of rust inhibitor paint mid one top coat of metal paint. 
Caulk around all openings with best grade of caulking compound. 

Steel Water Tanks— Clean and paint as specified for metal work. 

Roo/s— Roof cleaning or repair is not a part of this project. 

Dmmflge— Establish new drainage system on utility building annex. 



BALFORD AUTOMOTIVE PARTS, INC. 



179 



Justification 

The Utility Building, constructed in 1923, has a net book value of $215,000, 
and a book depreciation of $93,000. According to the records, the brick and 
concrete were repaired in 1942 and in 1944 at a cost of about $7,000, and 
in 1942 window-sash replacements were made, costing $2,600. 

The Annex, constructed in 1944, has a net book value of $24,000, and a book 
depreciation of $11,000. According to records, there has been no expense 
for repair work on this structure. 

The "A" storehouse, constructed in 1926, has a net book value of $68,000 
and a book depreciation of $36,000. The only repair expenditure was in 1955, 
when $2,300 was expended in an emergency to repair a structural failure 
in a bin wall. 

The repair and waterproofing of these structures will prevent extensive and 
costly future repairs. 

Photographs of some of the damage are shown in Exhibits 2, 3, 
and 4. 

The cost of the project was based upon a firm price quoted by 
Company A to Balford, and accepted by the company. Four firms 
bid for the waterproofing job, and their cost breakdowns were: 





Company A 


Company B 


Company C 


Company D 


Utility Building and Annex .... 


$28,834 


$22,465 


$20,340 


$30,004 


"A" Storehouse 


3,652 


1,320 


3,800 


3,967 


Subtotal 


$32,488 


$23,765 


$24,140 


$33,971 


Est. amount to complete 


3,988 
$36,476 


800 


4,000 
$28,140 


- 


Total 


$24,565 


$33,971 


Basis of bid 


Firm price 


Firm price 


(Est. - 
cost plus ) 


(Est. - 




cost plus ) 



What would be the effect of this restoration on the balance sheet 
and income accounts of the company? 



EXHIBIT I 

Cost of Project 

Restoring Utility Building, Annex and "A" Warehouse 
Detroit, Michigan 

Waterproofing concrete $19,423.50 

Cleaning and repairing concrete 8,906.00 

Establishing positive drainage at water table ... 4,351.00 

Painting all steel work 3,796.00 

Total cost $36,476.50 



180 



ACCOUNTING POLICY 



EXHIBIT 2 




i<<MM«KMK«t>wiMit^^»£^H^ 



West wall of Utility Building, showing the condition of pilasters, spandrel beams, 
and brickwork. Note the spiral reinforcing steel in columns. 



BALFORD AUTOMOTIVE PARTS, INC. 



181 



EXHIBIT 3 







Southwest exposure of water tanks and penthouses on Utility Building. Steel 
supports, tanks, and metal work require repainting, and brickwork and pent- 
house walls require repair and waterproofing. 



182 



ACCOUNTING POLICY 



EXHIBIT 4 




North wall of Utility Building, showing efflorescence of brickwork under window 
sills caused by leaking sills, permitting water to go into the wall. The concrete 
shows patches made in 1941-1944. 



EXHIBIT 5 

Definitions of Terms Used in Accounting Guides 
for Equipment and Buildings 

1. Additions 

Classified as additions are equipment or structures representing new and 
separate units or extensions of existing units. 

Related to additions are improvements or betterments. These are altera- 
tions or structural changes in a building or unit of equipment which result 
in a better piece of property in the sense of greater durability or increased 
productivity or efficiency. 

Within the levels set forth by types of machinery and equipment on the 
pages which follow, these expenditures are added to the Buildings and 
Equipment Account of the company. 



BALFORD AUTOMOTIVE PARTS, INC. 183 

a. Purchase of Used Equipment or Buildings 

All costs involved in the rehabilitation of the newly-purchased used 
equipment or buildings for productive use should be capitalized. Such 
used equipment or buildings should be appraised and the percentage 
of condition determined. The cost value divided by this percentage of 
condition determines the gross value which is set up on the records (in 
the General Office) with the excess over cost credited to the Allowance 
for Depreciation. 

b. Excessive Insfollotion Cosfs 

Excess installation cost due to unusual conditions or emergency require- 
ments is not capitalized but is charged to expense. In other words, 
property should not be carried on the book records at a gross value in 
excess of its normal reproduction cost at the time of installation. 

c. Painting 

The cost of repainting buildings or equipment is charged to expense. 
The cost of the first paint job of new equipment and buildings or newly- 
purchased buildings and secondhand equipment is capitalized, if this 
work is performed at the time of purchase. 



2. Replacements (including retirement) 

The retirement of units (or parts of units) and the addition of like or 
similar new units represent replacements. A physical repkicement of a 
unit does not necessarily result in an accounting for the transaction as a 
replacement. The unit must be sold, scrapped, or disposition otherwise 
made in order to receive this type of accounting treatment. Equipment 
which has been replaced, but retained on an inactive status, is not with- 
drawn from the capital accounts and consequently the cost of the new 
equipment is added in entirety to the gross book value of equipment. 

Two distinct accounting transactions are involved with replacements, 
as follows: the elimination (or retirement) of the old unit and the acquisi- 
tion of the new unit. The elimination of the old unit results in a credit 
to the Buildings and Equipment account and a charge to the Allowance 
for Depreciation for the book value of the unit retired. The value repre- 
sented by the acquisition of the new unit is an addition to the Buildings 
and Equipment account. 

Exceptions to the foregoing apply in the case of replacements of parts 
of units when the cost falls below $500. In these transactions, the cost of 
the replacement is charged to current operations. 

3. Expense 

The cost of incidental repairs which neither materially add to the value 
of the property nor appreciably prolong its life but keep it in an ordinarih- 
efficient operating condition is considered as maintenance expense. 



184 ACCOUNTING POLICY 

Within the limitations set forth by types of equipment, certain replace- 
ments of parts of equipment units are treated as maintenance expense. 

Costs of rearrangement of building areas are classified as maintenance 
expense since such changes generally do not add to the value of the 
property. 



Examples of Additions Representing Permanent Installations 

Additions of platforms, permanent walls for partitions, sound-proofing, 
garages, sheds, air conditioning, and heating equipment. 

Replacements and/or Retirements 

Demolition or removal of building units originally costing more than $200. 
(Examples: demolishing platforms, permanent walls, sidewalks, concrete 
pavements, as well as demofition of entire buildings.) 

Expenditures over $500 for replacement, reconstruction, or repairs (not 
in the nature of deferred maintenance ) . Expenditures subject to this treat- 
ment are, as follows: 

(1) Expenditures covering the entire replacement or reconstructions of 
major portions of the building, such as roofs, floors, large bins, plumb- 
ing, and lighting. 

(2) Expenditures occasioned by defective material or poor workmanship 
in the original construction. 

(3) Expenditures increasing the life of the building beyond the original 
estimate on which the depreciation is based. 

Expense 

Additions of items of less than $200 not reported as a part of a plant 
project. 

Additions of building units which are of a temporary nature and which 
do not increase intrinsic plant values. (Examples: temporary partitions,* 
false ceilings.) 

Replacements representing expenditures of less than $500 on one build- 
ing. 

Ordinary building maintenance such as painting or other work which 
must be done as often as once in five years. 



* A permanent wall is one which is an integral part of the building structure, A 
temporary partition is one which in case of removal would not affect the basic building 
structure. 



ease 



18 



TERRINI CONSTRUCTION COMPANY 

Purposes of Depreciation 

This case provides a springboard for a discussion of some of the 
factors which might influence a management in its choice of methods 
and rates of depreciation. 

In December, 1956, the executive committee of the Terrini Con- 
struction Company met to discuss, among other year-end matters, 
the company's depreciation poHcy on its mechanized equipment. 
The chief engineer had pointed out at the previous meeting that the 
depreciation charges amounted to over thirty per cent of his bid 
price on a construction job and he wanted to be sure they were right. 

The chief accountant started the discussion by stating that the 
Company's present method of computing the charge was to divide 
the cost of the equipment by its estimated Hfe and to charge this 
amount yearly to income. For bidding purposes the same figure was 
used, converted to a daily rate. 

The accountant went on to state that he did not believe this 
charge was quite accurate. He pointed out that the company was 
earning around ten per cent on its assets and that since the money 
represented by the depreciation charge was reinvested in the com- 
pany it earned additional income until the time came to buy a 
replacement piece of equipment. He said he had compiled some 
figures to illustrate this (Exhibit 1). The figures showed that the 
depreciation on a machine with a five-year life costing $10,000 would 
amount to about $12,200 at the end of the fifth year. The accountant 
believed the $2,200 ($12,200 — $10,000) to be excessive deprecia- 
tion. He suggested that a charge of $1,640 per year would be suffi- 
cient to replace the asset ( Exhibit 2 ) . The chief engineer then asked, 
with evident satisfaction, whether he could use the lower figure for 
bidding purposes, for this, he said, would enable him to insure suffi- 
cient business to keep the machines and men busy. 

"But," interjected the president's son, who had graduated the 

185 



186 



ACCOUNTING POLICY 



KXHIRIT 1 

Cost of Equipment: $10,000; Estimated Life of Equipment: 5 Years 



Year 


Depreciation 
Charge 


Factor * 


Depreciation 
Compounded to 
End of 5th Year 


1 
2 
3 
4 
5 


2,000 
2,000 
2,000 
2,000 
2,000 


1.46 
1.33 
1.21 
1.10 
1.00 


2,920 
2,660 
2,420 
2,200 
2,000 




12,200 



* The factor compounds the depreciation charge of $2,000 at the end of the first 
year to what it would equal at the end of the fifth year if it earned 10% interest 
compounded annually. 

EXHIBIT 2 

Cost of Equipment: $10,000; Estimated Life of Equipment: 5 Years 



Year 


Depreciation 
Charge 


Factor 


Depreciation 
Compounded to 
End of 5th Year 


1 

2 
3 
4 
5 


1,640 
1,640 
1,640 
1,640 
1,640 


1.46 
1.33 
1.21 
1.10 
1.00 


2,394 
2,181 
1,984 
1,804 
1,640 
10,003 



previous June from a business school, "where does this leave the 
U. S. Steel argument that their depreciation charges are inadequate 
to compensate for rising prices?" 

At this point the company treasurer entered the discussion by 
stating that it was "probably a good thing if depreciation charges 
were slightly excessive. A $10,000 piece of equipment," he went on 
to say, "bought five years ago certainly costs at least $12,200 today." 

The discussion continued for about ten minutes, the participants 
becoming more and more excited and apparently confused. Finally 
the president halted the talk and said that he thought nothing could 
be settled at that meeting. He suggested that the treasurer and the 
accountant give some thought to the issues raised by the discussion 
and determine whether any changes in the present depreciation 



TERRINI CONSTRUCTION COMPANY 187 

policy were needed. He then ended the meeting by remarking that 
the present method of computing depreciation charges had one 
strong advantage, and that was that it was simple to compute, easy 
to understand, and did not depend on changes either in prices or in 
company earnings. 



case 



19 



SHIPSTEAD ELECTRONICS CORPORATION 

Depreciation of Fixed Assets 

This case presents the problem of what top management should do 
about an apparent material over-depreciation of assets. Its problem 
includes the issue of disclosure to stockholders, the union, and the 
public. 

The Shipstead Electronics Corporation was a large producer of 
radios, phonographs, and television sets. The company also produced 
related electronic equipment in specialized fields for the govern- 
ment and private industry. Shipstead had plants throughout the 
world, and sales branches throughout the country. Although much 
of the production at Shipstead's plants was standardized, there were 
great technological advances which occurred too frequently to al- 
low Shipstead to manufacture a product of standard parts for more 
than five years. Of course, many of the components of the radio and 
television sets were standard equipment on all models, and this type 
of production somewhat simplified the replacement problem. 

Fixed assets at Shipstead were grouped by classes of assets. Depre- 
ciation rates were computed at specific rates by classes of asset on 
the gross value of all such assets in use by the company. For ex- 
ample, the company depreciated plants of frame and light steel con- 
struction at a three per cent rate on the basis of an estimated life of 
33I/3 years. If the asset remained in use beyond the estimated 
life, however, the company continued to depreciate the asset as long 
as there was any remaining undepreciated balance on this class of 
asset. If the frame and light steel plant had been built in 1910 at a 
cost of $200,000, it would be fully depreciated by 1944. The com- 
pany, however, would continue its yearly charge of $6,000 per year 
to operations as long as there was an undepreciated balance on all 
plant buildings of frame and light steel, despite the fact that for tax 
purposes depreciation stopped after $200,000 had been recovered. 
This policy served to build up a so-called secret reserve which off- 
set possible obsolescence of undepreciated assets. 



SHIPSTEAD ELECTRONICS CORPORATION 189 

EXHIBIT 1 

Summarized Balance Sheet— August 31, 1950 

ASSETS 

Current 

Cash $ 18,460,000 

U.S. Securities 4,370,000 

Accounts Receivable 34,540,000 

Inventories 53,722,000 

Prepaid Expenses 2,707,000 

Total Current $113,799,000 

Land, Buildings and Equipment $103,844,000 

Less accumulated depreciation 41,972,000 

$ 61,872,000 
Total $175,671,000 

LIABILITIES 

Current 

Accounts Payable $ 24,067,000 

Accrued Taxes 11,442,000 

Other 3,074,000 

Total Current $ 38,583,000 

Debentures-20 yr. Sinking Fund $ 16,400,000 

Capital Stock and Surplus 

Preferred Stock 31,000,000 

Common Stock 61,444,000 

Earned Surplus 28,244,000 

Total $175,671,000 

The effects of such a depreciation poHcy did not become pro- 
nounced so long as the company expanded. Shipstead had shown 
steady growth since its inception in 1902. Asset balances had con- 
tinued to grow each year despite depreciation charges. However, as 
the plants and equipment grew older and remained in use, and the 
rate of company expansion dropped off or ceased, the imbalance 
between assets and reserves for depreciation became accentuated. 
At August 31, 1950, the amount of such fully depreciated property 
still on the books and still being depreciated amounted to approxi- 
mately $16,000,000 out of a gross value of depreciable assets of 
$100,000,000. The depreciation reserve was $42,000,000, and total 
assets at Shipstead were $175,000,000. Sales for the 1949-1950 fiscal 
year amounted to $700,000,000, and profits after taxes were $20,- 
000,000. Supplementary data on the financial position of the com- 
pany and on its fixed assets are presented in Exhibits 1, 2, and 3. 



190 



ACCOUNTING POLICY 



EXHIBIT 2 

Supplementary Data 

Fixed Assets and Reserves for Depreciation 
August 31, 1950 



- 


Assets 


Reserve for 
Depreciation 


Land 

Buildings 

Stone 


$ 4,164,000 

22,404,000 

17,662,000 

3,174,000 

56,440,000 

$103,844,000 


$19,807,000 


Brick 

Other 


8,607,000 
824,000 


Machinery and Equipment 


12,734,000 




$41,972,000 



note: Depreciation charged operations for year ended August 31, 1950, totaled 
$3,864,000. 



Fully Depreciated Property, Based on Year of Acquisition 





Assets 


Depreciation 


Buildings 

Stone 

Brick 

Machinery 

Lathes, Punch Presses 

Knobbing and Curling Machines 


$ 13,200,000 
600,000 

2,564,000 
$ 16,364,000 


$16,047,000 
702,000 

3,176,000 
$19,925,000 



The setting of the depreciation rate at Shipstead was done by the 
chief accounting executive, the controller of the corporation. This 
rate was supposed to represent fairly the physical life of the plant, 
machinery, or equipment involved. Actually, however, the ma- 
chinery either lasted a longer or shorter time than expected, because 
of technological factors. The physical life of plants could be ex- 
tended almost indefinitely through preventive maintenance. In set- 
ting the life and rate of depreciation of an asset, the controller 
considered many factors: 

1. The tax rates allowable. 

2. Estimates of life made by manufacturers or contractors, en- 
gineers, or outside experts. 



SHIPSTEAD ELECTRONICS CORPORATION 191 

3. Miscellaneous factors, such as the use to which the plant or 
machine would be put, the price or cost of the article, fragility, 
or other manufacturers' experiences. 

Depreciation rates were changed if the controller believed 
that an error had been made in the original estimate, but only if the 
estimate affected the whole class of assets and not merely one asset. 

Naturally the depreciation method followed by Shipstead, since 
it was not allowed for tax purposes, compelled the company to main- 
tain two sets of records for fixed assets: one for taxes, and one for 
company use and annual report presentation. 

EXHIBIT 3 

Supplementary Data 

A sample survey of estimated remaining lives of fully depreciated assets now 
in use was made by the engineering office and, on sample, assets showed the 
following range : 

Estimated Remaining Life 

Stone Building— (No. 44) From 1 to 10 years 

Based upon technological improvements, physical condition, and com- 
pany policy pertaining to centralization of manufacturing facilities. It was 
estimated that the only resale value of building No. 44 was a nominal 
salvage value. 

Machinery— (Plant No. 24) 

Turret Lathes From 1 to 3 years 

Based upon present technological improvement, the present machines 
are obsolete. Within the next several years, savings from new equipment 
should justify the purchase of new equipment. 

Recently the company estimated that it was creating a hidden 
reserve of about $600,000 per year. The problem of what deprecia- 
tion policy to follow in the future assumed major proportions at 
Shipstead. The company did not expect its business to expand sub- 
stantially (nor even at the same rate as previously) in the next ten 
years. It believed that it would remain at approximately the same 
size, and that, over a period of years, the hidden depreciation re- 
serve would thereby become extremely large in relation to other 
asset and liability accounts. 

The company gave three reasons for maintaining its present policy. 
First, Shipstead believed that it should recover, through an adequate 
selling price, the cost of its operations. The corporation felt that it 



192 ACCOUNTING POLICY 

should protect the investment of the stockholders, both dollarwise 
and in relation to purchasing-power. It therefore reasoned that the 
product should bear the actual costs of operations, and not reflect 
paper profits which accrue because of low depreciation rates due to 
undervalued assets. Even though selling price was largely deter- 
mined by competition, the company believed that price was still 
influenced by what the manufacturer believed his price must be to 
cover his total costs and make a profit. Shipstead was afraid that if 
it did not depreciate on the gross asset balance of a group of assets, 
it would not recover the amount it should, and could, recover. 

The second reason given by the company for keeping the present 
depreciation policy was that, although this rate created a reserve 
when assets outlived their depreciable life, Shipstead lost from the 
reserve when assets were retired before they were fully depreciated. 
The reason for this was that Shipstead never charged income with 
the undepreciated balance ( gross value less salvage less depreciated 
amount gives undepreciated balance ) . Instead, the total gross value 
less salvage was deducted from the depreciation reserve. Since the 
depreciation rate was based upon average estimated life, the ap- 
parent hidden gains and losses should have negated each other. 
Shipstead further argued that even though a reserve was being 
built up at the rate of $600,000 annually, it was impossible to deter- 
mine obsolescence accurately in an industry as competitive and 
technologically advanced as radio, and that any year might bring 
an unexpected change which would cause Shipstead to scrap old 
machinery and buy new equipment. 

Finally the third reason why Shipstead was hesitant about shift- 
ing depreciation programs was the tremendous effect such a change 
would have initially on the balance sheet. The reserve would then 
become a "profit" in the eyes of the public, labor, and the stock- 
holder, and pressures would be exerted upon Shipstead manage- 
ment by each group. Management at Shipstead was afraid that these 
pressures might seriously hamper the efficient operation of the 
company. 

The controller of Shipstead has asked you to say what you think 
should be done with regard to depreciation of fixed assets. Your 
review should present specific proposals both for record keeping 
purposes and for treatment in the annual report. 



ease 



20 



BIGHORN DRILLING COMPANY 

Depreciation Policy 

This case involves further consideration of some of the issues raised 
by the Terrini Construction Company case in connection with the 
question of depreciation. It broadens the area of discussion by rais- 
ing the implication of depreciation methods to operating decisions of 
management. 

Introduction 

In December, 1956, the newly-appointed controller of the Big- 
horn Drilling Company began to examine the company's deprecia- 
tion policy for drilling rigs and drill pipe. Basically, he set out to 
determine whether the company's existing depreciation practice 
provided adequate information for use in costing bids on new work 
and in determining the company's profit on its drilling operations. 

The question of an equitable rate for bidding purposes had been 
raised frequently by the operating departments in recent months 
because industry bidding practices had become increasingly com- 
petitive and because the company had been operating at only sixty 
per cent of capacity in recent months. In determining the profit- 
ability of drilling operations, the controller wondered whether one 
rate or a series of different rates was best suited to the several pur- 
poses of evaluating management performance, reporting progress to 
stockholders, and reporting profits for federal and state tax purposes. 

Contract Drilling Operations 

Depreciation was a highly significant cost element in the contract 
drilling business. To illustrate the relative importance of the depre- 
ciation charge to Bighorn, it might be noted that depreciation 
charges normally amounted to approximately three to four per cent 
of manufacturing costs of General Motors Corporation. In the Big- 
horn Drilling Company, depreciation charges amounted to approxi- 
mately twenty per cent of direct drilling costs in 1956. 

193 



194 ACCOUNTING POLICY 

When an oil "operator" wanted a well drilled, he drew up specifica- 
tions on the well and sent out bid requests to a selected group of 
drilling contractors such as Bighorn. The drilling contractors would 
then submit sealed bids stating a per-foot price, such as $10.50 per 
foot for a 13,000 foot well. In addition to the footage bid, each con- 
tractor submitted a daywork bid, which might amount to about $900 
for a 24-hour day. The operator paid the contractor at the daywork 
rate whenever delays arose which were beyond the control of the 
contractor. An example would be delays in drilling while the sub- 
structure formations were being tested for oil. In preparing footage 
bids, the key variable was the expected number of drilling days that 
would be required to drill a well. 

In estimating drilling time, the contractor used geologic informa- 
tion and drilling records on old wells compiled by the operators and 
service companies, as well as his own records. The contractor multi- 
plied the estimated drilling days by his daily operating costs and 
divided by the number of feet to get an approximate cost per foot 
for bidding purposes. The number of contractors bidding on a well 
varied, depending on the availability of rigs in the region and on the 
number of drillers the operator wished to solicit. Seldom did a con- 
tract driller know definitely who else was bidding or, if he lost, what 
the accepted price was. The industry typically kept cost and price 
information closely guarded. 

Although Bighorn Drilling Company operated fourteen rigs, the 
industry was characterized by a large number of small companies, 
many of which had only one rig. Investment in one rig, however, 
ran from one-quarter to one-half million dollars and each rig re- 
quired an additional investment of around $100,000 in drill pipe. 
Most of the small companies were privately owned, with the pro- 
prietor making the bids on new business. In such companies, cost 
records were scarce and often poorly kept. Maintenance practices 
on equipment were carefully carried out by some companies, among 
them Bighorn, but many companies had no maintenance programs 
and simply worked their rigs to exhaustion. 

Drilling equipment was generally separated into two classifica- 
tions: drilling rigs and drill pipe. Drilling rigs were classed by their 
maximum depth capabilities and consisted of an assembly of com- 
ponents. The most important components were the derrick or mast, 
the engines, pumps, compounds, and the draw- works; this latter was 



BIGHORN DRILLING COMPANY 195 

a gear and pulley system enabling the engines to turn or lift the 
drill pipe. Besides these major components, a host of lesser pieces of 
equipment were required for the operation of a rig. 

The rig's operation was handled by a foreman, known as a tool- 
pusher, and fifteen or more men, working on three 5-man tours or 
shifts. The toolpusher was in charge of the rig's operation, ordered 
and signed for supplies, and supervised the maintenance and repair 
of equipment. The preparation of cost records and the purchase of 
new equipment was handled by the home office. 

Controller's Investigation 

Prior to December, 1956, Bighorn's drilling department kept rec- 
ords on the cost of drilling operations, which it used to help make 
up bids and to evaluate the performance of the rigs and of the de- 
partment as a whole. Another set of cost records was kept by the 
accounting department primarily for reporting to stockholders, to 
state and federal government tax agencies, to top management, and 
to the board of directors. 

The two sets of records differed in several ways, one of the most 
important of which was in the treatment of depreciation. The drill- 
ing department depreciated drilling rigs separately and at a differ- 
ent rate from drill pipe; the accounting department depreciated both 
rigs and pipe together at a fifteen per cent annual rate. In Decem- 
ber, 1956, the controller was asked to clarify the situation; top man- 
agement, the drilling department, and the board of directors were 
all interested in evaluating the performance of the drilling opera- 
tions and wished to know which set of records, if either, was more 
useful for this puropse. 

The controller began his analysis of the drilling department's op- 
erating results by studying the bases for the various depreciation 
charges which had been made. With this information as a back- 
ground he planned to gather what facts he could relating to the 
actual lives and prices of the equipment in order to test the accuracy 
of the rates being used. With the results of this analysis he could 
provide a more accurate picture of the drilling department's operat- 
ing performance. 

Balance sheets and income statements for the company are shown 
in Exhibits 1 and 2. These were prepared by the accounting depart- 
ment for reporting to the government and to stockholders. 



196 



ACCOUNTING POLICY 



EXHIBIT 1 

Year-end Balance Sheets— in Thousands 



Assets 


Sept. 30, 1955 


Sept. SC 


), 1956 


Cash 

Accounts receivable 


$ 87 

1,027 

617 

746 

$ 312 

4,121 

388 

29 


$2,477 

1,910 

241 

$4,628 

$ 649 

47 

1,299 

2,633 

$4,628 


$ 464 
727 
462 
965 

$ 316 
4,674 * 
433 
29 

$5,452 
3,327 

$ 640 
92 

33 

482 

2,153 




Incomplete contract wells 

Supplies 




Total current assets 


$2,618 


Land and buildings 

Drilling rigs and pipe 

Vehicles and office equipment 

Gas lines 








Total fixed assets 


$4,850 
2,940 

$ 597 

52 

33 

482 

2,118 




Less reserve for depreciation 

Total net fixed assets 

Deferred charges 


2,125 
295 


Total Assets 


$5,038 






Liabilities 




Accounts and notes payable 

Accrued taxes 




Total current liabilities 


$ 732 


Deferred Liabilities 


78 


Long-term note 


1,560 


Common stock 

Capital surplus 




Earned surplus 








Total equity 




2,668 


Total Liabilities 


$5,038 







Approximately $1.13 million of this is drill pipe. 



Depreciation Rates Used by the Drilling Department 

In making up its contract footage bid on a well the drilling de- 
partment estimated the number of days the work would take and 
then based labor and material cost requirements on this estimate. 
To this total was added the overhead and depreciation charges each 
of which was a predetermined daily rate multiplied by the esti- 
mated number of drilling days to be spent on the well. For example, 
the drilling department estimated that a particular 12,000-foot well 
would take 105 days, that $55,400 would be spent on labor supplies 
and maintenance, and that $45,600 would be spent on bits, and on 



BIGHORN DRILLING COMPANY 



197 



EXHIBIT 2 



Income Statements— Years Ending September 30— in Thousands 
(Excerpts from accounting department figures) 



Total revenue 

Total expenses 

Depreciation 

Net profit before taxes . . . 
Rig activity— % of maximum 

Total revenue 

Total expenses 

Depreciation 

Net profit before taxes ... 
Rig activity— % of maximum 



1947 



$2,566 

2,165 

374 

28 



1948 



$2,641 

1,945 

342 

354 



1949 



$2,785 

2,174 

439 

171 



J 950 



$3,195 

2,628 

441 

127 



1951 



$3,500 

2,725 

489 

286 

79.9 



1952 



1953 



1954 



1955 



1956 



54,458 

3,352 

589 

517 

79. 



$3,877 

2,888 

666 

324 

76.7 



$3,932 
3,294 
733 
(95) 
64.5 



$3,826 
3,225 
691 
(90) 
76.1 



$4,765 

3,982 

741 

43 

82.3 



Income Statements for Years Ended September 30, 1955 and 1956- 
in Thousands (Accounting department figures) 





1955 


1956 


Drilling tool revenue 


$3,752,934 

73,281 

$3,826,215 

3,002,939 
225,346 

$3,228,285 

$ 597,930 

67,884 

$ 665,814 

65,552 

$ 600,262 

690,418 

$ (90,156) 



$ (90,156) 


$4,748,511 


Miscellaneous income 


16,474 


Total income 

Drill tool expense 

Administrative expense 

Total expense 

Net income from operations 

Income from interest, discounts, sale of assets .... 

Less interest expense 

Less depreciation 

Net income or loss before taxes 

Provision for income taxes 


$4,764,985 

3,744,742 

221,915 

$3,966,657 

$ 798,328 

73,841 

$ 872,169 

89,141 

$ 783,028 

740,344 

$ 42,684 




Net income after taxes 


$ 42,684 



198 ACCOUNTING POLICY 

transportation of the rig, fuel, and water. Overhead was to be al- 
located at the rate of $110 a day or a total of $11,550 for the well. 
Depreciation for the rig to be used had been set at $100 per day and 
for the drill pipe, $63.49 per day, making a total depreciation charge 
of $17,166 for the well. To the total footage cost of $129,716 a profit 
margin was added which might be 0-15% of total costs depending 
on competitive factors and the company's desire to get the job. 

The daywork bid was based on certain parts of the footage bid; 
it was usually the sum of the per-day costs of labor, supplies, mainte- 
nance, and fuel, and the daily overhead and rig depreciation charges. 
For the well described above the daywork costs were estimated to 
be $768 per day to which a profit margin was added in forming 
the bid. 

Until 1955 the drilling department's depreciation charges for drill- 
ing rigs had been based on original cost and a 2,000 drilling-day life. 
As will be noted below, the drilling department frequently departed 
from this objective method of computing depreciation. Ten per cent 
salvage was deducted from the original cost to find the depreciable 
value, since this was customary in tax computation and since there 
always was some salvage value in a worn-out rig. 

The depreciation practice of the drilling department may be illus- 
trated by its handling of depreciation charges for rig number 37. The 
original cost of rig 37 was $322,900. Based upon this cost, a 2,000-day 
life, and a 10% salvage value, the depreciation charge should have 
been set at $145 per day. The actual charge when the rig was 
bought in August, 1948, was set at $138 a day but it w^as subse- 
quently raised on January 1, 1953, to $146, and lowered again a year 
later to $138 as a result of the difficulty encountered in securing con- 
tracts based on the higher cost. 

On January 1, 1956, when the daily rates on all rigs were reduced, 
the daily charge on rig number 37 went from $138 to $100. The 
changes were brought about partly by competitive . pressures and 
partly as a result of a reconsideration of the 2,000-day life. Two 
thousand days would be equivalent to a seven-year life if the rigs 
were in use 75% of the time, and management decided at the end 
of 1955 that the rigs would actually last longer than this. 

On August 1, 1956, the daily depreciation charge on rig number 
37 was increased from $100 to $150 a day as part of a move to 
standardize the diff^erent depreciation charges on the seven rigs in 



BIGHORN DRILLING COMPANY 



199 



EXIIIIIIT it 



Drilling and Accounting Department Income Statements 
Year Ending September 30, 1955 





Drilling Dept. 
Cost Summary 


Accounting Dept. 
Income Statement 


Difference 


Drilling income 

Direct drilling expense .... 

Gross profit 

Overhead 


$3,740,667 
3,003,222 

$ 737,445 
282,445 


$3,826,215 

3,002,939 

$ 823,276 

225,346 
$ 597,930 

$ 690,418 

67,884 

(65,552) 

$ (90,156) 


$ 85,548 

283 

$ 85,831 


Administrative expense . . . 


57,099 


Income from operations . . . 
Rig depreciation 


$ 455,000 

318,361 

146,539 

$ 464,900 


$ 142,930 


Drill pipe depreciation .... 

Total depreciation 

Other income 


$(225,518) 
67,884 


Interest expense 


(65,552) 


Profit before taxes 


$ (9,900) 


$ (80,256) 



Drilling and Accounting Department Income Statements 
Year Ending September 30, 1956 





Drilling Dept. 
Cost Summary 


Accounting Dept. 
Income Statement 


Difference 


Drilling income 

Direct drilling expense ... 
Gross profit 

Overhead 

Administrative expense .... 


$4,741,634 

3,678,610 

$1,063,024 

404,082 


$4,764,985 

3,744,742 

$1,020,243 

221,916 

$ 798,327 

$ 740,344 

73,842 
(89,141) 
$ 42,684 


$ 23,351 
(66,132) 

$ (42,781) 

182,166 


Income from operations . . . 

Rig depreciation 

Drill pipe depreciation .... 

Total depreciation 

Other income 


$ 658,942 

402,680 

221,053 

$ 623,733 


$ 139,385 

$(116,611) 

73,842 


Interest expense 


(89 141) 






Profit before taxes 


$ 35,209 


$ (7,475) 



200 



ACCOUNTING POLICY 



EXHIBIT 4 

Schedule of Drill Pipe Depreciation Rates 1952 Through 1956 



Depth of the 

Well to he 

Drilled (feet) 


Depreciation 

Per Day 

1952 


Depreciation 

Per Day 

1953 


Depreciation 

Per Day 
1954 and 1955 


Depreciation 

Per Day 

1956 


4,500 


$39.38 
42.68 
45.83 
48.84 
51.70 
54.44 
57.07 
59.57 
61.98 
64.29 
66.50 
68.63 
70.67 
72.64 
77.78 
82.73 
87.50 
92.10 


$33.75 
36.59 
39.29 
41.86 
44.31 
46.65 
57.07 
59.57 
61.98 
64.29 
66.50 
68.63 
70.67 
72.64 
77.78 
82.73 
87.50 
92.10 


$32.14 
34.84 
37.41 
39.87 
42.20 
44.44 
46.58 
48.63 
50.59 
52.47 
54.28 
56.02 
57.69 
59.30 
63.49 
67.53 
71.42 
75.18 


$38.16 
41 37 


5,000 


5,500 


44 43 


6,000 


47 34 


6,500 

7,000 


50.12 

52 77 


7,500 


55 31 


8,000 

8,500 


57.75 
60 08 


9,000 


62 31 


9,500 


64 46 


10,000 


66.52 


10,500 


68 50 


11,000 


70 41 


12,000 


75.39 


13,000 


80.19 


14,000 


84.82 


15,000 


89.28 







The 1956 rates are equivalent to the following rates per foot per day at three depths 



When drilling 
at this depth ( feet ) 

5,200 

9,000 

13,000 



Rate per foot 
per day is 

l.2(t 



the 15,000-foot class, of which number 37 was one of the oldest. The 
rates had differed between rigs within one class not because of any 
difference in equipment or capability, but because the cost price, on 
which the rates were based, varied between rigs. Though the older 
rigs had cost less, the management thought that within their useful 
life they were just as capable as the new rigs and, therefore, wished 
to charge a standard average depreciation rate on all the rigs in 
each class. Although bidding purposes were dominant in setting the 
scale for depreciation charges, identical rates were used by the drill- 
ing department for bidding, costing, and preparation of internal 
operating statements. 

When the well was finished, a contract footage cost sheet and 
contract daywork cost sheet were made up showing the actual out- 



BIGHORN DRILLING COMPANY 201 

of-pocket costs incurred on a well and the estimated depreciation 
and overhead costs based upon the actual number of days and the 
daily factors. At the end of the year, the sum of the daily deprecia- 
tion charges incurred by operation of the rigs was entered in a drill- 
ing department cost summary sheet. Exhibit 3 shows the cost 
summary figures for the years ending September 30, 1955 and 1956, 
and a reconciliation with the accounting department's figures for the 
same period as shown previously in Exhibit 2. 

The drill pipe depreciation charge which the drilling department 
included in its bid was computed for each well at a rate per day 
per depth of the well to be drilled. The charges shown in Exhibit 4 
were computed by a rather complicated formula, part of which ac- 
counted for the rate of penetration and the time required for lower- 
ing and for pulling out the drill pipe. The 1956 rates correspond 
roughly to the three rates per foot per day for wells of various depths 
shown at the bottom of Exhibit 4. 

As with rigs, the depreciation charges on pipe were entered on the 
bid and cost sheets and at the end of the year the total of the cost 
sheet charges was entered in the drilling department's cost sum- 
mary sheet. 

Depreciation Rates Used in the Accounting Department 

For reporting to both the stockholders and the government, the 
Bighorn Drilling Company charged against income a flat deprecia- 
tion rate on the average gross investment in both rigs and drill pipe. 
This so-called composite rate method of depreciation was calculated 
as follows : To the beginning balance of gross investment was added 
the cost of additions made during the year, and from that sum was 
subtracted the year's reductions, leaving a final balance of gross 
investment. A percentage of the average of the beginning and end- 
ing balances was the depreciation sustained for the year and was 
charged to the reserve. The balance in the reserve account could 
never exceed 90% of the gross account, since it was assumed there 
would always be a 10% salvage value. The Bighorn Drilling Com- 
pany had started this system in 1946, using a 25% depreciation rate, 
but subsequently on recommendation both by the company's audi- 
tors and by the Internal Revenue Service the rate was reduced in 
1950 to 17%, and again in 1954 to 15%, which was the rate used in 
the year ending September 30, 1956. 



202 



ACCOUNTING POLICY 



The controller made one final notation in his study of past depre- 
ciation rates. Since 1952 the accounting department had been capi- 
talizing expenditures on major overhauls of equipment by charging 
them directly to the depreciation reserve account. The drilling de- 
partment, on the other hand, charged the overhaul expenditures as 
direct drilling expenses. Exhibit 5 shows the amounts which had 
been charged over the last five years by the accounting department 
to the depreciation reserve. The left-hand column shows the ac- 
counting department's depreciation charge for rigs and pipe. Since 
Bighorn also owned trucks, automobiles, buildings, and other assets, 
the total depreciation charge for all assets shown in Exhibit 2 was 
somewhat greater than the depreciation charge for rigs and drill 
pipe shown in the first column of Exhibit 5. The second column of 

EXHIBIT 5 

Major Overhaul Charges 
(Accounting Dept. Figures) 





Depreciation on 


Overhauls 


Net Change 




Rig and Drill 


Charged to 


Depreciation 




Pipe 


Reserve 


Reserve 


1947 


323 




323 


1948 ,...,. 


294 




294 


1949 


401 




401 


1950 


399 




399 


1951 


446 




446 


1952 


531 


1 


530 


1953 


597 


9 


588 


1954 


573 


69 


504 


1955 


601 


85 


516 


1956 . , 


651 


140 
304 


511 



Exhibit 5 shows overhauls charged to the reserve, and the third 
column shows the net change in the depreciation reserve as reported 
by the accounting department. The controller considered that this 
column showed what the net charge for depreciation on rigs and 
drill pipe by the accounting department would have been if major 
overhauls had been charged to expense rather than capitalized. As 
such, the figures in the last column should correspond with the drill- 
ing department's charge since that department did charge overhauls 
to expense. ' 



BIGHORN DRILLING COMPANY 203 

Controller's Examination of Rig Life and Prices 

Having collected information on what the depreciation rates had 
been, the controller set to work gathering and examining informa- 
tion on what the future depreciation policy of the company should 
be. The following four tabulations were made: 

1. The age, original investment, and replacement cost of each rig 
in use on September 30, 1956: Exhibit 6. 

2. The estimated present resale value of two rigs in each class: 
Exhibit 7. 

3. The present age and original investment cost of some of the 
major items of equipment used on each rig: Exhibit 8. 

4. The age at the time of trade of those rigs which were traded 
for new rigs over last ten years: Exhibit 9. No other rigs were 
sold. 

Mr. Able, the vice-president in charge of drilling, was asked for 
his opinion on the life expectancy of rigs. He had been in the drilling 
business all his life, working his way up through many positions to 
his present post in which he was directly responsible for bidding on 
contracts and for drilling performance. 

Mr. Able said that in his opinion "maintenance and depreciation 
are tied together," and that there is "no such thing as obsolescence 
in this business now." There were different ways, he said, of treating 
drilling equipment which would affect its life. One could spend prac- 
tically nothing on maintaining it and when breakdowns occurred 
either replace or overhaul the equipment; or one could periodically 
inspect and maintain the equipment as he had done in Bighorn. 
With his preventative maintenance policy he said annual mainte- 
nance costs were high (see Exhibit 10), but expensive breakdowns 
were fewer, safety was improved, and equipment life extended. 

Mr. Able also pointed out that all pieces of equipment on drilling 
rigs do not wear out at once, but rather that the components must be 
replaced at different times. As a rough approximation of the order 
in which the major items would wear out, he cited the following 
order of components: rotary table and swivel would wear out first, 
followed by the pumps, the engines, the draw-works, and the crown 
and travel block. "The derrick," he said, "never wears out." On the 
whole rig, he said, the 2,000-day life was too short; rather he thought 
about 15 years at 70% utilization would be closer. 



204 



ACCOUNTING POLICY 



EXHIBIT 6 

Age, Investment, and Replacement Costs of Drilling Rigs 
September 30, 1956 



Rig No. and Class 


Age 


Actual 

Original 

Investment 


New 

Replacement 

Cost 


Class 1-7,500' 

8 

26 

36 

Average 


2 yr., 7 mo. 

6 yr., 9 mo. 
4 yr., 2 mo. 
4 yr., 6 mo. 

2 yr., 10 mo. 

3 yr., 11 mo. 

4 yr., 5 mo. 
4 yr., 10 mo. 

4 yr., mo. 

8 yr., 6 mo. 

8 yr., 2 mo. 

5 yr., 11 mo. 

9 yr., 7 mo. 
2 yr., 5 mo. 

10 yr., 3 mo. 
5 yr., 3 mo. 

7 yr., 2 mo. 


$247,202 
143,952 
192,211 
194,455 

$351,515 
315,820 
282,900 
268,327 
304,640 

$296,055 
322,887 
301,132 
246,968 
445,337 
163,488 
237,026 
287,556 


$320,000 
265,000 
275,000 
287,000 


Class 11-10,000' 

15 

24 

33 

38 

Average 

Class 111-12,000-15,000' 

9 

37 

39 

40 

41 

42 

44 

Average 


$435,000 
435,000 
422,000 
420,000 
428,000 

$475,000 
505,000 
483,000 
460,000 
502,000 
440,000 
510,000 
482,000 



EXHIBIT 7 



Estimated Present Value of Rigs 
September 30, 1956— in thousands 



Rig Number 


Date of 
Acquisition 


Age 


Original 
Cost 


Present 
Value * 


Replacement 
Cost 


Class I 

26 

36 

Class II 

24 

33 

Class III 

37 

40 


December 1949 
July 1952 

October 1952 
April 1952 

July 1948 
February 1947 


6 yr., 9 mo. 
4 yr., 2 mo. 

3 yr., 11 mo. 

4 yr., 5 mo. 

8 yr., 2 mo. 

9 yr., 7 mo. 


$144 
192 

$316 

283 

$323 

247 


$ 70 
82 

$180 
170 

$210 
120 


$265 

275 

$435 
422 

$505 
460 



* Amount to be realized upon sale. 



BIGHORN DRILLING COMPANY 



205 



EXHIBIT 8 

Major Items of Equipment 
September 30, 1956 



Item 



Total 
Investment 



Average 
Age in Years 



Age of 
Oldest 



Age of 
Newest 



Draw-works 

Engines 

Pumps 

Compounds 

Derricks 

B.O.P 

Brakes 

Tanks 

Rotary tables 

Feed controls . . . . 

Houses 

Travel blocks . . . . 
Crown blocks . . . . 

Swivels 

Total investment 



$ 559,440 

444,888 

426,240 

415,584 

264,402 

161,172 

132,534 

99,234 

71,262 

66,600 

60,606 

43,956 

43,956 

37,296 

$2,827,170 



5.6 
5.6 

8 
5.6 

7.4 
7.4 
5.6 



7.9 
7.6 
8.6 



9 
12 
15 

9 
12 
13 

9 
16 
15 

8 
12 
13 
11 
15 



notes: 1. Age is calculated back to the date of manufacture (estimated in cases of 
used equipment ) . 
2. Investment is the actual purchase price, new or used. 



EXHIBIT 9 

Schedule of Age of Rigs When Traded 



Rig 
Number 



Age 



8 10 years, 8 months 

15 8 years, 1 month 

29 7 years, 5 months 

33 6 years, 1 month 

34 5 years, 9 months 

24 5 years, 10 months 

36 Second-hand— Based on date of manufacture 6 years, 1 month 

Based on date purchased by Bighorn ... 4 years, 11 months 

26 8 years, 7 months 

38 Second-hand— Based on date of manufacture 5 years, 7 months 

Based on date purchased by Bighorn ... 3 years, 2 months 

40 Second-hand— Based on date of manufacture 7 years, 4 months 

Based on date purchased by Bighorn ... 2 years, 7 months 

39 Second-hand— Based on date of manufacture 5 years, 11 months 

Based on date purchased by Bighorn ... 3 years, 5 months 

Whenever a rig is traded, the new rig maintains the number of the rig it replaces. 



206 



ACCOUNTING POLICY 



EXHIBIT 10 

Maintenance Costs— Average Total Cost and Average Cost 
per Day by Class of Rig and Year 



1952 



1953 



1954 



1955 



1956 



Class I 

Average total cost . . . 
Average cost per day 

Class II 

Average total cost . . . 
Average cost per day 

Class III 

Average total cost . . . 
Average cost per day 



$33,848 
161 

$18,727 
262 

$50,308 

242 



$24,812 
186 

$39,654 
216 

$45,373 
224 



$29,724 
188 

$41,071 
216 



$30,639 

238 



$21,499 
148 

$32,623 
164 

$40,454 
205 



$26,318 
140 

$37,159 
206 

$37,692 
197 



The controller decided that, while collecting information on the 
life of rigs, it would be useful to know something about the price 
changes which had taken place. Although it was Mr. Abie's conten- 
tion that "the only basis for depreciation is original cost," the con- 
troller felt that some cognizance of the changes in replacement cost 
was necessary for sound financial administration. As a result, he 
gathered the information on price changes shown in Exhibit 11. 

Controller's Examination of Drill Pipe Life and Prices 

The controller turned next to drill pipe. It was clear that drill pipe 
lasted a shorter length of time than the rigs and was usually used 
until worn out. For as short a period as five years, it was possible to 
make a useful comparison between actual costs of pipe and the 
depreciation charges which were reported each year by the drilling 
department on its summary cost sheet. The actual cost of pipe used 
was obtained by computing a depreciated value for the pipe in- 
ventory on September 30, 1951, adding to this the recorded pur- 
chases of pipe during the succeeding five-year period, and subtract- 
ing from the sum the depreciated value of the ending inventory. 
The total five-year cost calculated by this method was $1,290,000; 
the total pipe depreciation charged by the drilling department 
over the same period was $1,299,000. 

The similarity of these depreciation and cost figures indicated to 
the controller that the drilling department's charges for pipe depre- 



BIGHORN DRILLING COMPANY 



207 



EXHIItIT 11 



Indices of Prices Based on Actual Purchases 
of Three Rig Components and Drill Pipe 



Year 


Engines * 


Draw-works * 


Rig Tables * 


Drill Pipe * * 


1947 First half 




85 






1947 Second half 










1948 


100 
100 


100 
99 


100 
115 




1948 




1949 


111 








1949 










1950 










1950 




106 


126 


100 


1951 










1951 










1952 










1952 






131 


107 


1953 






139 


116 


1953 


164 






121 


1954 


163 
170 




146 
153 




1954 


125 


1955 




129 






1955 


179 




165 


135 


1956 








142 


1956 


195 


150 


180 


155 



* Base period: First half of 1948. 
** Base period: Second half of 1950. 



elation were close to the actual costs of the pipe during the five-year 
period. To see how these figures compared with the accounting de- 
partment's 15% flat rate, he compared an average of the drilling 
department's yearly charges for the five-year period ($260,000) 
with a figure for average drill pipe investment in the same period 
($1,286,000). The latter figure was an average of the five figures 
representing average pipe investment for each of the five years. The 
two figures showed that for the five-year period the average drilling 
department depreciation rate on pipe had been 20.2% of the aver- 
age investment in pipe during each year. 

In order to examine the magnitude of the different charges on the 
books, which would have resulted from different depreciation rates 
on rigs and drill pipe over the past ten years, the controller prepared 
the table shown in Exhibit 12. For a basis of comparison he showed 
the accounting department charges and the aggregate drilling de- 
partment charges for the same period. He noted that for compara- 



208 



ACCOUNTING POLICY 



EXHIBIT 12 

Depreciation Charges 

Past depreciation charges as shown by the drilling department and the 
accounting department— in thousands 



Year 


Drilling Department 


Accounting 
Department 




Rigs 


Drill Pipe 


Total 


Rigs and Pipe 


1947 

1948 

1949 . ; 

1950 

1951 

1952 

1953 

1954 

1955 

1956 

Total 


$ 205 
178 
215 
256 
278 
325 
292 
311 
318 
403 

$2,781 


$ 89 
81 
125 
132 
178 
186 
161 
151 
147 
221 

$1,471 


$ 294 
259 
340 
388 
456 
511 
453 
461 
465 
624 

$4,251 


$ 323 
294 
401 
399 
446 
531 
597 
573 
601 
651 

$4,816 



B. Depreciation which would have been charged if the following three combinations 
of rates on rigs and pipe had been charged over the past 10 years— in thousands 





Combination 1 


Combination 2 


Combination 3 


Equivalents 


Rigs 
10% 

8% 
6% 

Pipe 

22.5% 
20.0% 
18.0% 


$2,339 
1,355 


$1,871 
1,203 


$1,404 

1,084 

$2,488 


9 year hfe, 10% salvage or 
8 year life, 20% salvage 
10 year life, 20% salvage 
15 year life, 10% salvage 

4 year life, 10% salvage 

4 year life, 20% salvage 

5 year life, 10% salvage 




$3,694 


$3,074 





bility with the drilhng department figures and with the three test 
combinations, the accounting department depreciation charges 
should be reduced by the major overhaul charges shown in Exhibit 
5. This would reduce the $4,816,000 total to $4,512,000. At the same 
time the accounting department expense figures should be increased 
a like amount if the accounting department profits were to be un- 
aftected by the adjustment. 



BIGHORN DRILLING COMPANY 209 



Conclusion 



The controller now had all the information he could reasonably 
assemble from the company's records. From this data his task was 
to draw some conclusions for internal management purposes as to 
how well the drilling department had actually done in the past five 
to ten years. He would also be called upon to recommend a depreci- 
ation policy stating what rates should be charged in the future. It 
was questionable whether the Internal Revenue Service would 
continue to allow a fifteen per cent composite rate. The usefulness 
of this rate for reporting to stockholders was also in doubt. And, 
nnally, internal management wanted to know what sort of reports 
could be made which it could count on in the future to show an ac- 
curate picture of the performance of the drilling operation. 



ease 21 

THE REECE CORPORATION 

The Impact of Inflation on Corporate Reporting 

This case provides a framework within which the impact of price level 
changes on financial reporting may be considered. It examines the 
efforts of a smaller company to bring this phenomenon to the atten- 
tion of its stockholders and the public in general. 

During 1953, the American Accounting Association, under a grant 
from the Merrill Foundation for the Advancement of Financial 
Knowledge, undertook a research project on the effects of inflation 
on capitalistic enterprise. As a part of its research project, the As- 
sociation planned a series of four case studies of American corpora- 
tions. 

One of the companies offering to cooperate in the study was The 
Reece Corporation of Waltham, Massachusetts. Mr. Franklin Reece, 
the president, had long been concerned with the possible misunder- 
standing and danger arising during a period of inflation in which no 
planned account is given in published statements of the changes 
taking place in the purchasing power of the dollar. 

In the case study. The Reece Corporation was discussed as follows : 

The Reece Button Hole Machine Company was founded and incorporated 
in 1881 under the laws of the state of Maine for the purpose of producing and 
marketing John Recce's invention, the first machine automatically to stitch 
eyelet-end buttonholes in the high button shoes of that day. In the following 
year, a second Maine corporation, The International Button Hole Sewing 
Machine Company, was separately capitalized and became the exclusive 
marketing agent for Reece products in foreign countries. 

From its inception, the Company has specialized in automatic sewing ma- 
chines for such short cycle stitching operations as button sewing, tacking, short- 
seam overedging, and eyelet stitching in addition to the many varied kinds of 
buttonhole sewing required by the shoe and garment industries. The Company, 
it is believed, was among the first to lease exclusively rather than sell its 
products. This policy was followed until 1930 when an irrevocable ninety-day 
option to purchase or lease was granted to customers upon the installation of 
new equipment. 

In 1948, the two original companies merged to form a new Massachusetts 
corporation, The Reece Corporation. In 1949, its manufacturing departments 

210 



THE REECE CORPORATION 211 

were moved from Boston to Waltham, and in 1954 the administrative, sales, 
and engineering departments also were moved there. The Company maintains 
branch offices for sales and service in twenty major garment producing centers 
in the United States. Five subsidiary companies and twenty-eight agents in 
thirty-three foreign countries sell, lease, and service its products abroad.^ 

As a result of the study conducted by the American Accounting 
Association with The Reece Corporation, The Reece Corporation 
began including information in its annual report on the price level 
problem. In its seventy-fourth annual report for the year ended 
December 31, 1955, The Reece Corporation included the data shown 
in Exhibit 1. 

Do you think this step by The Reece Corporation is a desirable one 
for it to take? Should other corporations do the same? 

What other steps, if any, should corporations take to bring the price 
level problem to the attention of their stockholders and the public? 

Do you anticipate Mr. Brooks, the treasurer, will get much response 
from his request? What type of response do you think it will be? 



EXHIBIT I 

Excerpt from the Annual Report for Year Ended December 31, 1955 

The purpose of the Price Level Study is to compare the Company's financial 
statements as prepared by conventional accounting with these same statements 
after adjustment to show the effect of inflation. 

In applying the Price Level Study to the Company's figures, we compare 
Historical Dollars— those with which we are all sadly familiar and which have 
lost more than half their purchasing power in the last fifteen years— with Uni- 
form Dollars. The Uniform Dollar used is defined as a uniform measuring unit 
whose purchasing power is equal to the 1955 dollar. In order to prepare the 
accompanying charts, the Company's financial statements from 1940 to date 
have been restated in 1955 Uniform Dollars by means of index numbers based 
on the Consumers Price Index. For chart purposes, both Historical Dollar and 
Uniform Dollar amounts have been expressed as a percentage of 1940 in order 
to establish a common point of departure. 

From the first chart, it is apparent that, in Historical Dollars, Gross Income 
was almost four times as large in 1955 as it was in 1940, whereas in Uniform 
Dollars it is only about twice as large. 1955 net income after taxes in Historical 
Dollars is 2.9 times as great as that for 1940, yet in Uniform Dollars it is only 
1.4 times as large. 



1 Ralph C. Jones, Case Studies of Four Companies ( Columbus, Ohio : American 
Accounting Association, 1955), p. 110. 



212 



ACCOUNTING POLICY 



•/o OF 1940 
400 



300 



200 



GROSS INCOME 
1940-1955 



100 































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1940 41 42 43 44 45 46 47 48 



50 51 52 53 54 55 



% OF 1940 NET 
INCOME BEFORE 
INCOME TAXES 



400 



NET INCOME 

BEFORE AND AFTER TAXES 

1940-1955 



300 



200 



100 

















— 


















1 








INCOME TAXES IN ^^m NET INCOME AFTER TAXES 
UNIFORM DOLLARS ^H IN UNIFORM DOLLARS i 














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1940 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 



THE REECE CORPORATION 213 

Fortunately, the Price Level, or cost of living, has increased only slightly 
in the last four years; therefore conventional accounting methods, which entail 
the use of Historical Dollars, do not seriously distort the income statement for 
1955. Nevertheless, in converting 1955 figures to Uniform Dollars, we find that 
depreciation, charged without regard for actual replacement cost, is understated 
by $49,000 and taxable income overstated by $44,000, the difference represent- 
ing an adjustment to cost of sales. It follows that the Federal Income Tax 
applicable to these fictitious earnings is a tax on capital. 

Studying a Company's financial statements when expressed in Uniform 
Dollars has a sobering effect in these days of high production, apparently high 
profits, and general prosperity. The true growth of a company becomes ap- 
parent, the false basis of taxable income is highlighted and, in the case of this 
Company, one finds that earnings plowed back in the business are only about 
fifty-eight per cent as large as indicated by conventional accounting practice. 

The rising cost of machinery and buildings over the last fifteen years is one 
of the most serious problems that face manufacturing companies. These costs 
have gone up significantly faster than is indicated by the Consumers Price 
Index which has been used in preparing this Price Level Study. Unfortunately, 
we do not know of a Price Index that could properly be applied to a manufactur- 
ing concern so we have used the Consumers Price Index, but we recognize that 
it falls short of indicating the full eff^ect of inflation on this Company. The 
Price Level Study indicates that the Company's reserves for depreciation are 
25% or $703,000 less than they should be. No doubt the true inadequacy of the 
reserves is nearer 40%, or more than $1,000,000. As equipment wears out or 
becomes obsolete, it must be replaced. Since depreciation reserves are inade- 
quate to provide for replacement, retained earnings or borrowed money must be 
used to help pay for the replacement equipment. 

We believe that the comparison of financial results in Historical Dollars with 
those converted to Uniform Dollars is an invaluable management tool. However, 
the theory and application of the Price Level Study is difficult to understand 
even after considerable study. Therefore, we wonder if it is of interest to readers 
of this report. Would you please note on your proxy whether or not you think 
we should include this section in future reports. 

W. D. Brooks, Jr., Treasurer 



case 



22 



THE PAN AMERICAN COMPANY 

Intangible Assets 

This case deals with a problem of determining a specific course of 
action involving the application of generally accepted accounting 
principles. The issue of conflicting courses of action, both apparently 
justifiable under "generally accepted accounting principles/' is 
considered. 

The Pan American Company, one of the country's largest supphers 
of printing inks and related chemicals, had just completed acquisi- 
tion of a subsidiary late in 1956. With home offices in Chicago, the 
company had eight plants scattered throughout the country and 
sales offices in all of the principal cities. The following data were 
taken from its 1955 annual report : 

Sales $100,106,000 

Net Profit after Taxes 4,707,000 

Total Assets 58,075,000 

Capital Stock 7,440,000 

Capital Surplus 10,365,000 

Earnings Retained in Business 16,740,000 

Goodwill 1 

Immediately after the legal matters pertaining to the new acqui- 
sition had been settled, the president had a meeting with his con- 
troller and treasurer to discuss the effect of the acquisition on the 
balance sheet of the company. 

The following facts about the new acquisition were all agreed 
upon : 

Purchase price in stock of 

Pan American Company - . $740,300 

Tangible Assets acquired $490,300 

Excess of purchase price over book 

value of assets acquired 250,000 

$740,300 



214 



THE PAN AMERICAN COMPANY 215 

The amount of $250,000 representing excess of the purchase price 
over book value of assets acquired did not include any trademarks 
or patents of any significant value. 

The president said that, as the company had not made a practice 
of showing goodwill at other than the nominal value of one dollar, 
he would prefer to write off the goodwill against capital surplus. The 
treasurer said this would be improper; the write-off would have to 
be against earned surplus. The controller disagreed with both, say- 
ing goodwill would have to be capitalized and written off against 
future earnings. 

To prove his point, the controller had prepared a memo ( Exhibit 
1) showing what Colgate-Palmolive-Peet Company had done in 
1946 when it acquired Kay Daumit, Inc. 

The treasurer said this was only one example, and he could sup- 
port his own view if necessary. The meeting broke up to resume 
at a later date. 

A few days later the treasurer brought in certain data on General 
Foods and its acquisition of Perkins Products Company, manufac- 
turers of Kool-Aid, in May, 1953 (Exhibit 2). 

"See," he said, "my example is later and just as good as the 
controller's." 

"Well," said the president, "apparently accounting rules and con- 
ventions will let you do anything you please. Give me a good, 
logical reason why I can't do what I prefer with our small acqui- 
sition." 



EXHIBIT 1 

Acquisition of Kay Daumit, Inc., by Colgate-Palmolive-Peet Company 

On November 30, 1946, Colgate-Palmolive-Peet Company acquired, through 
purchase, Kay Daumit, Inc., and Daumit Beauty Products, Inc. The agreement 
by which Colgate bought Daumit provided that $3,750,000 be paid for the 
goodwill, patents, and formulas of Daumit and $381,892 for the combined net 
worth (exclusive of goodwill, patents, and formulas). Part of this consideration 
was payable in cash, and part in the stock of the Colgate company. The stock 
to be paid to Daumit consisted of 37,193 shares of common stock of the Colgate 
company, valued for such purposes at the average closing price of the common 
stock on the New York Stock Exchange during November, 1946 ($47.35 per 
share) . The remainder was paid in cash. 



216 ACCOUNTING POLICY 

Summary of Transaction 

Assets Acquired: 

Tangible $ 381,892 

Goodwill 3,750,000 

$4,131,892 

Payment: 

Capital Stock $1,761,089 

Cash 2,370,803 

; . . - - $4,131,892 

Data from Balance Sheet of Colgate-Palmolive-Peet Company 
■ December 31, 1945 

Sales $135,368,000 

Net Income transferred to Surplus 7,036,000 

Total Assets 76,400,000 

Capital Stock 37,000,000 

Capital Surplus 1,800,000 

Earned Surplus 21,500,000 

Goodwill 1 

In its financial statements, Colgate-Palmolive-Peet Company capitalized the 
$3,750,000 of goodwill and stated that it was being written off over a ten-year 
period. 

EXHIBIT 2 

Acquisition of Perkins Products Company by General Foods 

In May, 1953, General Foods acquired the Perkins Products Company, pay- 
ing $13,676,814 through the issuance of 249,520 shares of capital stock of 
General Foods. Of the amount of $13,676,814, the company immediately wrote 
off the portion assigned to intangibles ($6,237,000) against earned surplus. 

Summary of Transaction 
Purchase Price $13,676,814 

Capitalized $ 7,439,814 

Intangibles Written off at Date of Acquisition . . 6,237,000 

- ' ^ ,, $13,676,814 

Data from Balance Sheet of General Foods 

March 31, 1953 ' ^ - 

Sales $755,919,000 

Net Income transferred to Surplus 24,807,000 

Total Assets 219,016,000 

Capital Stock 142,795,000 

Earnings Retained in the Business 76,222,000 

Trademarks, Patents and Goodwill 1 



section FOUR. 



The Role of Financial Analysis 
in the Management Process 



A PHASE OF BUSINESS MANAGEMENT WHICH HAS REALLY JUST BEGUN TO 

come into its own during the past twenty or so years, and which remains 
perhaps the most undeveloped aspect of the controller function, is the 
use of various analytical tools to develop from raw accounting and 
statistical data information necessary for management purposes. The case 
materials in this section are designed to provide training in that part of 
the controller's duties having to do with figure analysis. Some of the 
cases deal with analysis leading to management decisions, while others 
are concerned with the comparison of actual performance with the 
results expected from decisions made in the past. All of them require a 
highly analytical approach and force the student to bridge the gap 
between the routine production of accounting figures and the manage- 
ment functions of decision-making and follow-up. 



A. Financial analysis as an aid in making management decisions 

23. Star Slipper Company 

24. Bowl-A-Way 

25. Continental Oil Company 

26. Velox Oil Company 

27. Blackstone Mining Company 

28. Acadia Auto Accessories, Incorporated 

29. The New England Baking Company 



217 



218 THE ROLE OF FINANCIAL ANALYSIS 

B. Financial analysis as an aid in measuring performance by 

FUNCTION OR BY ORGANIZATIONAL UNIT 

30. Global Chemical Company 

31. The South American Coffee Company 

32. Albertson Steel Company 

33. The Wright Knight Company 

34. Hydrocarbon Products Company, Inc. 

35. Birch Paper Company 

36. Long Manufacturing Company 

37. Borah Petroleum Company 

38. Clark Chemical Company 



case 



23 



STAR SLIPPER COMPANY 

Problem of Product Mix 

This case involves a management decision on a product mix problem. 
It focuses on the cost analysis necessary to provide a sound basis 
for determining the effect on profits of dropping a product from the 
company's line. 

In July, 1956, Mr. Lester Grant and Mr. Daniel Rogerson, presi- 
dent and treasurer, respectively, of the Star Slipper Company were 
trying to reverse the unprofitable record which the 18-month-old 
company had made since the two officers started its operations. 
During June they had collected cost information which was more 
detailed than that which they had been using, and Mr. Grant thought 
that with it they could come to some definite conclusions. Some 
plan for remedial action, he said, was needed soon, in view of the 
present financial condition of the company. (See Exhibits 1 and 2.) 

The Star Slipper Company manufactured two lines of slippers 
and casual shoes whose retail selling price ranged from $1.98 to 
$4.98. The two lines differed in their basic construction design. In 
the "Jenson" line the top part of the shoe was stitched to the sole, 
whereas in the "Bond" line the top and the sole were cemented 
together by machine. Although the selling price ranges overlapped, 
most of the Bond line was lower-priced than the Jenson line. 

Star produced the slippers only on firm orders and, except for 
special rush orders, delivery was usually made months after an 
order was placed. Orders were usually large, since the customers 
were well-established shoe store chains, department stores, or shoe 
wholesalers. At times, however. Star acted almost as a storage agent 
for its customers' inventory, and for this reason finished goods in- 
ventory was valued at its sale price on the statements used for 
internal management purposes. 

When the company was organized, its basic business was con- 
sidered by Grant and Rogerson to be the Jenson slippers; the Bond 

219 



220 THE ROLE OF FINANCIAL ANALYSIS 

EXHIBIT I 

Balance Sheet June 30, 1956 

Assets 

Cash $ 941.81 

Receivables 

Trade (pledged) $198,678.49 

Other 14,525.00 213,203.49 

Merchandise Inventory 425,020.25 

Current Assets $639,165.55 

Fixed Assets-Cost $ 96,812.27 

Depreciation Reserve 21,520.05 $ 75,292.22 

Prepaid and Organization 

Expenses 10,347.79 

Total Assets ' $724,805.56 

Liabilities 

Accounts Payable-Trade - $235,755.82 

Notes and Loans Payable 365,458.60 

Accrued Taxes and Payroll 30,972.30 

Current Liabilities $632,186.72 

5% Debenture Ronds-Due 1965 $ 92,500.00 

Preferred Stock $ 60,500.00 

Common Stock 30,000.00 

Accumulated Losses 90,381.16 * 

Net Worth 118.84 



Total Liabihties $724,805.56 

* Red figure. 

line was added to use some of the excess production space in the 
five-story plant and to contribute to the company's basic overhead 
cost. Except for a few operations the Bond and Jenson slippers were 
produced on separate lines. "It is almost like two separate plants," 
Mr. Grant commented. Only on the few operations common to both 
lines were workers supposed to work on both Bond and Jenson 
slippers. However, as plans turned out, some indirect labor worked 
on both production lines and occasionally direct labor was shifted 
between lines. 

When production started, there were two foremen, two repairmen, 
a cobbler, and about twenty-five production workers assigned to the 
Bond line. However, difficulties appeared in the production process, 



STAR SLIPPER COMPANY 



221 



EXHIBIT 2 

Income Statements 
(For internal management uses only) 





Year to 
Dec. 31, 1955 


6 months to 
June 30, 1955 


6 months to 
June 30, 1956 


Sales— Bond 

— Jenson 


$177,305.72 

615,469.08 

125.50 

$792,900.30 

2,746.33 

$790,153.97 

0.00 

$542,479.77 

203,943.41 

11,669.25 

17,196.85 

$775,289.28 

133,591.40 

$641,697.88 

148,456.09 

$117,368.25 

26,650.82 

52,338.24 

$196,357.31 

$ 47,901.22 t 
8,909.76 

7,996.94 
3,762.76 
$ 11,759.70 
$ 50,751.16 t 


$ 55,701.80 

123,995.50 

125.50 

$179,822.80 

0.00 

$179,822.80 

0.00 

$225,343.45 

65,363.60 

3,951.23 

7,006.08 

$301,664.36 

174,056.48 

$127,607.88 

52,214.92 

$ 50,620.95 

11,994.57 

25,394.00 

$ 88,009.52 

$ 35,794.60 1 
903.69 

1,200.63 
602.81 
$ 1,803.44 
$ 36,694.35 | 


$236,690.83 
172,437.17 


—Seconds 

Total 

Less Returns 


1,309.30 

$410,437.30 

3,522.71 


Net Sales . 


$406,914.59 


Beginning Inventory * 


$133,591.40 ** 


Purchases less discounts 

Direct Labor 


393,068.01 
181,333.54 


Payroll Taxes 

Freight in and Royalties 

Total 

Ending Inventory * 


10,783.63 
13,079.96 
$731,856.54 
425,020.25 f 


Cost of Goods Sold 


$306,836.29 : 


Gross Profit on Sales 

Factory Overhead 

Selhng and Shipping 

Administration and General .... 
Total Operating Expenses .... 

Loss from Operations 

Other Income 


100,078.30 

$ 87,366.77 f f 

15,632.89 

28,360.56 

$131,360.22 

$ 31,281.92 t 
1,259.91 

7,330.28 

2,277.71 
$ 9,607.99 
$ 39,630.00 t 


Other charges: 

Interest 

Other 

Total 

Net Loss for Period . . 







* Since slippers were produced only on iirm orders, iinished goods inventory was valued at the selling 
price. 

** Inventory at the start of the year was almost all raw material. 

t Approximately $64,000 of this was Bond slippers, $227,000 was Jenson slippers, and the rest was raw 
material. 

tt Includes $34,479.52 of indirect labor (inspectors, repairmen, cobblers, etc.). 

I Red figure. 



quality suffered, and two repairmen and four inspectors were added 
to cut the number of customer returns. Exhibit 3 Hsts the number 
of workers on the Bond Hne in July, 1956, and their approximate 
annual pay. 

For each item to be produced, a cost sheet was made, showing the 



222 



THE ROLE OF FINANCIAL ANALYSIS 



EXHIBIT 3 

Workers on the Bond Line— July 1, 1956 

Approximate Annual Pay per Man 

2 Foremen $5,000 

4 Repairmen 3,000 

1 Cobbler 3,000 

4 Inspectors 3,500 

25 Pieceworkers 3,600 



EXHIBIT 4 

Schedule for Overhead Charges for 1956— 
Jenson slippers (per pair) 



Retail Price 


Estimated 
% of Total Volume 


Overhead to Be Charged 


$4.98 
3.98 
2.98 

L98 


10% 
40% 
30% 

20% 


$.40 
.38 
.36 
.34 



material and labor cost per dozen pairs and an allocated overhead 
figure. The material cost was based on estimates or, when available, 
actual cutting records and yardage cost. Labor cost was mostly 
piece-rate work with some hourly labor in addition. The overhead 
allocation was made at the beginning of the year by estimating the 
total overhead and the sales volume in pairs at different prices. An 
average overhead charge was then calculated and adjusted to dif- 
ferent prices in such a way that if volume and mix came out as 
estimated, all overhead would be absorbed. For example, the $1.98 
(retail) slipper carried 34 cents of overhead, and the $4.98 slipper, 
40 cents of overhead. (See Exhibit 4.) 

The cost sheets were used in pricing and as a basis for decisions 
on the adoption of new products. The manufacturer's selling price 
was usually determined by the customary retail selling prices of 
$1.98, $2.98, $3.98, etc. There was, however, some flexibility in the 
manufacturer's selling price, since the retailer's margin could vary 
with differences in material or with pressures of supply and demand 
at the time the order was given. Mr. Grant would decide whether 
to accept an order by adding material, labor, allocated overhead, 
and a five-cent profit per pair and comparing this total with the 



STAR SLIPPER COMPANY 



223 



EXHIBIT 5 

Cost Summary Sheet 







Jenson 


Line 




Bond Line 


Model 


A 


B 


C 


Weighted 
Average * 


D 


Date First Order 


Nov. 19, 1955 


Jan. 15, 1956 


Nov. 30, 1955 




Apr. 9, 1955 


Material per Dozen . . 


17.50 


12.21 


7.96 


13.52 


8.17 


Labor per Dozen 












(piecework) 


5.71 


6.21 


4.04 


5.50 


3.63 


Overhead per Dozen . . 


4.56 


4.32 


4.08 


4.38 


3.36 


Factory Cost per 

Dozen 


27.77 


22.74 


16.08 


23.40 


15.16 


Profit 


.60 


.60 





.47 





Total Cost 












per dozen 


28.37 


23.34 


16.08 


23.87 


15.16 


per pair f 


2.36 


1.94 


1.34** 


1.99 


1.26 


Selling price 

per dozen 


28.20 


22.20 


14.70 


23.40 


15.36 


per pair 


2.35 


1.85 


1.25** 


1.95 


1.28 


Retail Price 


3.98 


2.98 


1.98 











" The weights used were the percentages of total volume shown in Exhibit 4. 

** Slippers made with three grades of material were all sold at $1.25 in about equal amounts. Costs per 
pair with the other two grades were $1.31 and $1.26. These variations were included in the weighting 
process. 

t Cost per pair is a rounded figure and, therefore, is not exact in all cases. 



selling price he thought he could get. The cost and profit figures 
seldom matched the selling price exactly but sometimes left a larger 
than expected profit above the allocated overhead, and sometimes 
no profit at all. The absence of projected profit did not necessarily 
mean that Mr. Grant would reject the order, for often a counteroffer 
at a higher price would be accepted by the customer. Furthermore, 
Mr. Grant had occasionally accepted orders which yielded no profit 
above the allocated overhead. 

Exhibit 5 shows Cost Sheet Summaries of three of the highest 
volume Jenson slippers and the major slipper in the Bond line. Mr. 
Grant indicated these were typical and representative of each of 
the lines. 

In early 1956, Mr. Grant began to suspect that most of the losses 
the company had been sustaining were caused by the Bond line of 



224 THE ROLE OF FINANCIAL ANALYSIS 

EXHIBIT 6 

Direct Labor Costs by Product Line (per pair) 





Jenson 


Bond 


Piecework 

Day Labor * 


.400 

.039 

.038** 

.010 

.009 

.496 


.308 
.067 


Hourly Time 

Make-up f f 

Overtime 


.059 f 

.069 

.009 


Total 


.512 



* Inspectors and cobblers. 

** .003 of this was for production of samples, .012 for repairs, and .023 for work for which there were 
no piece rates. 

t .003 of this was for production of samples, .044 for repairs, and .012 for work for which there were 
no piece rates. 

tt Pay for training time or other time when piecework pay did not come up to guaranteed pay. 



slippers. Accordingly, in May, labor costs for each product line were 
recorded separately for the first time. Exhibit 6 shows figures for 
the five different categories of labor which were average for the 
eight-week period preceding June 30. 

Before coming to any conclusion on the profitability of the Bond 
line, Mr. Grant examined the consequences of various decisions. If 
no change in sales policy were made, Bond slipper sales of about 
$350,000 could be expected by the end of the year. This might be 
increased to $400,000 if special efforts were made to get the slippers 
to new customers, but Mr. Rogerson said that this second figure was 
pretty much a ceiling for the present Bond line. 

Mr. Grant said that there were more workers on the Bond produc- 
tion line in June, 1956, than should be needed. Since operations had 
begun, extra repairmen and inspectors had been added to maintain 
adequate quality. Even though the superintendent had been spend- 
ing most of his time on this problem, little improvement had resulted, 
and Mr. Grant was uncertain how long it would take before the 
number of inspectors and repairmen could be reduced to the normal 
complement with which the line had started. 

If the Bond line were to be dropped entirely, Mr. Grant thought 
that he could get along without the superintendent, who was nearly 
ready to retire anyway, and also save about $5,000 in office and 
shipping expenses annually. He would also be able to ship his rented 



STAR SUPPER COMPANY 225 

machines back to the United Shoe Machinery Company for about 
$1,500, ehminating an annual rental of $2,500. And, finally, Mr. Grant 
estimated that an additional $3,000 in general overhead expenses 
would also be eliminated. 

What course of action would you prescribe for the Star Slipper 
Company? 



case 



24 



BOWL- A- WAY 

Appraising Capital Expenditure Projects 

The Bowl-A-Way case deals with a decision concerning the expendi- 
ture of capital funds. It focuses on the analysis necessary to establish 
the alternatives open to a company and on the choice from among 
those courses of action. 

In August, 1955, Mr. Nathan Peters decided to build Bowl-A-Way, 
an amusement center with sixteen bowHng alleys, on a well traveled 
highway near Boston. The plans were completed except for possible 
provisions for resetting pins, and Mr. Peters was debating whether 
to use pin boys or pinsetting machines. There were three such ma- 
chines available for purchase, two of which could also be obtained 
under lease arrangements. One of the latter two machines could be 
rented under a contract which included an arrangement whereby 
the lessee could buy at a later date at a reduced price. 

Pin Boys 

Mr. Peters knew that the initial cost would be low if the decision 
were made to use pin boys. He was afraid, however, that there was a 
chance that the presence of pin boys might have an adverse effect 
on the type of customers he hoped to attract. He expected that a 
large part of his business would come from children, families, and 
mixed bowling leagues. He had noticed that pin boys working at 
other alleys sometimes behaved in a manner which might not make 
the best impression on this type of customer. In any case he knew 
that careful supervision would be necessary. 

The only investment required if pin boys were employed would 
be about $25 per alley for pinsetting guides. The going rate in the 
area for setting pins was 12 cents a string,^ to which indirect labor 
costs such as social security, unemployment compensation, and ac- 



1 A string, or game, is a series of ten frames in which one, two, or three balls are 
bowled. 

226 



BOWL-A-WAY 



227 



cident insurance would add about 20 per cent. Five boys were 
usually needed to operate four alleys; a total of twenty would be 
required for the proposed sixteen alleys. These employees would 
have to be drawn from the 16- to 18-year age group since the mini- 
mum legal age was 16 and boys over 18 could normally find higher 
paying jobs. 

Pinsetting Machines 

Three makes of pinsetting machines were available: Bowl-Mor 
pinsetters made by Bowl-Mor Corporation of Everett, Massachusetts; 
Bowlfast pinsetters made by Simmons Machine Tool Corporation 
in Albany for Bowling Machines, Inc.; and Greer pinsetters made by 
the J. W. Greer Company in Wilmington, Massachusetts. Bowl-Mor 
and Bowlfast machines could be either bought or leased, but the 
Greer Company offered its machines only for sale. 

Purchase Arrangements 

All three machines sold for $3,600 each. (See Exhibit 1.) Freight 
and installation charges on the Bowlfast and Greer machines were 
paid by the manufacturer, but the customer paid for these charges 
on the Bowl-Mor machines. Bowl-Mor Corporation charged $125 
per machine for installation and estimated that the freight cost to 
Mr. Peters would be $10 per alley. The parts of Bowlfast and Greer 
machines were guaranteed for one year; Bowl-Mor's warranty cov- 

EXHIBIT 1 

Data for Purchasing Pinsetting Machines 





Bowl-Mor 


Bowlfast 


Greer 


Purchase 

Purchase price 

Installation 

Freight ... 


$3,600 

125 

10 

90 days 

75% 

6% 

36 months 


$3,600 
included 
included 

1 year 

80% 

6% 

48 months 


$3,600 
included 
included 


Guarantee 

Parts and Labor 


30 days 
1 year 

75% 

6% 

36 months 


Parts 

Financing 

Part which can be financed 

Interest 

Repayment period 







228 



THE ROLE OF FINANCIAL ANALYSIS 



ered only ninety days. Greer also agreed to pay any labor charges 
incurred for the replacement of parts in the first thirty days; neither 
of the other companies made this offer. 

Financing could be arranged by all three companies. Bowlfast 
agreed to finance 80 per cent of the sales price over 48 months, and 
the other two would finance 75 per cent over 36 months. All three 
firms charged interest of 6 per cent per year on the total amount of 
the loan. 

Lease Arrangements 

Bowl-Mor and Bowlfast machines could be leased under the fol- 
lowing conditions: The rent on the Bowl-Mor machine (Exhibit 2) 
was $720 a year for four years, and would probably be $480 there- 
after. An initial lease of four years would be required, followed by 
four-year leases at the option of the lessee. The uncertainty of the 
rental fee after the initial lease period was due to the fact that very 
few machines had been in operation in the area for four years, and 
fees for subsequent lease periods would be subject to negotiation. 
Freight and installation costs on the Bowl-Mor machine would be 
paid by the lessee; insurance on the machine would be paid by the 
manufacturer. 

The rental fee on Bowlfast machines was ten cents a string with a 
minimum fee of $40 a month on an initial lease of four years. Subse- 
quent four-year leases could probably be negotiated at five cents a 
string and $40 a month minimum. The manufacturer of the Bowlfast 
machines paid the freight, installation, and insurance costs. The 





EXHIBIT 2 






Data for 


.easing Pinsetting 


Machines 


-■ 




Bowl-Mor 


Bowlfast 


Greer 


Annual Rent- 
First four-year period 


$720 


$.10 per string 
minimum of $40 
per month 


No Rental 


Annual Rent- 
Subsequent periods 


$480 


$.05 per string 
minimum of $40 
per month 




Freight 

Installation 


$10 by lessee 
$125 by lessee 


paid by lessor 
paid by lessor 




Insurance 


paid by lessor 


paid by lessor 









fiOWL-A-WAY 229 

manufacturers of both Bowl-Mor and Bowlfast pinsetters employed 
servicemen to do major repair work on the machines; most alleys, 
however, did their own minor repair work and maintenance. 

Option to Purchase 

The lease arrangements for the Bowl-Mor machines gave the 
lessee an option to buy the machine at three different points during 
the four-year lease. When the machine was six months old, it could 
be purchased with 80 per cent of the total past rental payments ap- 
plied to the original price. At 24 months 60 per cent of the past rents 
could be applied to the purchase price, and at 48 months 40 per cent 
of the past rents could be applied. 

Option for Reduced Rent on a Longer Lease 

There was also included in the Bowl-Mor lease an option to sub- 
stitute a seven-year lease at $540 a year. This option could be exer- 
cised only after sixteen months of the original lease, and would 
thereby extend the total lease period to eight years, four months. 
If this option were elected, the purchase option would no longer 
apply unless the $15 a month difference were paid for all the months 
in which the reduced rent had been paid. 

Volume of Business 

It was expected that the alleys could be open daily from 2 p.m. to 
11 P.M., but the volume of business which might be available was not 
easy to predict. The charge for bowling would be 25 cents a string 
before 5 p.m. and 35 cents from 5 p.m. until 11 p.m. Mr. Peters 
thought that with an alley in constant use a pin boy would set an 
average of six strings an hour. But since constant use would only 
occur in the evening hours, he estimated that thirty strings a day per 
alley was all that could be reasonably expected if pin boys were 
used. The pinsetting machines, however, had a capacity speed of 
eight strings an hour and Mr. Peters anticipated that with machines 
he would average forty strings a day per alley. 

Some Additional Factors 

There were some additional factors Mr. Peters had to consider. 
Each machine would require electrical power extensions costing 
about $150 per alley. If he bought the machines, his annual property 



230 THE ROLE OF FINANCIAL ANALYSIS 

insurance costs would rise $14 per alley. He would have to hire a 
maintenance man for around $75 a week whether he bought or 
rented the machines. 

Electrical power costs were expected to be relatively insignificant. 
Each machine had six fractional horsepower motors; the one-third 
and one-sixth horsepower motors ran continuously; the other four, 
which amounted to one horsepower (about 1,000 watts), ran eleven 
seconds during each cycle, about twelve of which were required on 
the average to process a string. The electrical power would cost $.01 
per kilowatt hour. 

Mr. Peters examined each of the three machines in operation and 
came to the conclusion that there was little difference in their re- 
liability or speed. The Bowl-Mor machine was perhaps slightly less 
noisy but on the whole each did the job satisfactorily. In addition, 
there seemed to be no reason why one machine would last longer 
than another, though just how long they would last was difficult to 
determine. They would surely last for five years, and probably for 
ten. All machines could be modified for around $35 each year, the 
manufacturers said, to keep abreast of design improvements. If this 
were done, the machines would almost certainly last for ten years. 
There had been almost no major improvements over the past three 
years, and none of the companies appeared to be working on any 
radical improvements for the near future. 

Mr. Peters now had all the information he could gather on pin 
boys and pinsetting machines. Any saving in operating costs which 
might result from use of the machines would be partially offset by an 
increase in the income tax liability, which he expected would be 
about 30 per cent of income before taxes. His next task was to ar- 
range and interpret the facts so that he could compare the use of 
pin boys and pinsetting machines, and so that he could determine 
which machine would cost him the least and whether to consider 
buying or leasing. . 

What course of action would you recommend to Mr. Peters? 



case 



23 



CONTINENTAL OIL COMPANY 

Appraisal of Capital Investments 

This case deals broadly with the area of capital budgeting. It raises 
such questions as the handling of uncertainty, cost of capital, and the 
discounting of future cash flows, as these factors relate to the de- 
cision as to whether to accept or reject specific capital projects. It 
also raises many of the administrative problems which are involved 
in establishing and implementing a capital budgeting policy for a 
company. 

The Continental Oil Company is an integrated oil company, rank- 
ing among the twenty largest oil companies incorporated in the 
United States. Its marketing operations cover the central and Rocky 
Mountain portions of the United States; refining and pipeline facil- 
ities are located in these same areas. Producing facilities are located 
from the Williston Basin in Montana, North Dakota, and South 
Dakota to offshore wells on the Louisiana coast, and from California 
to Indiana. 

Financial Data 

Consolidated balance sheets of the company for December 31, 
1954, and December 31, 1953, as they appeared in the annual report 
of the company for 1954 are shown in Exhibit 1. 

The statement of consolidated income and earned surplus for the 
year ended December 31, 1954, and December 31, 1953, is shown 
in Exhibit 2. 

A summary of the highlights of the financial and operating aspects, 
also taken from the 1954 annual report, is shown on pages 232- 
233. 

The Problem 

In the summer of 1954 the president of the Continental Oil Com- 
pany asked one of his assistants and the controller to review the 

231 



EXHIBIT 1 

Consolidated Balance Sheet at December 31, 1954, 
and December 31, 1953 



Assets 


1954 


J 953 


Current Assets: 

Cash 

U.S. Government and Other Securities at Cost, 

Which Approximates Market 

Notes and Accounts Receivable 


$ 36,243,060 

34,118,968 
53,032,241 

40,284,064 

10,172,798 

$173,851,131 

$ 16,996,408 

15,695,009 

$ 32,691,417 

$709,540,825 

440,297,798 
$269,243,027 
$ 4,413,851 
$480,199,426 


$ 23,668,323 

11,585,301 
41,482,219 


Crude Oil and Refined Products at Cost, Deter- 
mined on the Last-in, First-out Basis, Lower 
Than Aggregate Market 

Materials and Supplies at or Below Average Cost . 
Total Current Assets 


43,865,935 

9,331,202 

$129,932,980 


Investments and Advances at Cost, Less Reserves: 

Controlled Companies Not Consolidated 

Other 


$ 2,194,783 
26,433,628 


Property, Plant and Equipment, Substantially at 
Cost 
Less: Reserves for Depreciation, Depletion, and 
Intangible Development Costs 

Prepaid and Deferred Charges 

[Continued on page 233] 


$ 28,628,411 
$639,110,576 

392,454,976 
$246,655,600 
$ 4,205,926 
$409,422,917 



procedures which were being used in the various departments of 
the company for the appraisal of new capital investments. In view 
of the fact that the company's capital expenditures ran in the neigh- 
borhood of $100 million a year, the president felt it was important 
for the company to have adequate means of measuring the relative 
desirability of alternative investment projects. 

The report which was submitted by the two men late in 1954 is 





1954 


1953 


Net Earnings 

Total 

Per Share 


$41,683,189 

$4.28 

$25,341,108 

$2.60 

$100,043,648 


$40,874,666 
$4.20 


Dividends 

Total 

Per Share 

Capital Expenditures ... 


$25,315,104 

$2.60 
$84,967,792 








232 







Liabilities and Stockholders' Equity 






Current Liabilities: 






Accounts Payable and Accrued Liabilities 


$ 47,423,527 


$ 37,960,455 


Accrued Taxes, Including Provision for Federal 






Income Taxes 


12,222,588 


18,773,511 


Long-term Debt Due Within One Year 


- 


5,000,000 


Total Current Liabilities .... 


$ 59,646 115 


$ 61 733 966 


Long-Term Debt: 






Thirty-year Sinking Fund 3% Debentures, Due 






November 1, 1984 (Redeemable $4,000,000 






Annually Commencing 1960) 


$100,000,000 


$ 


3^4% Notes 


— 


45,000,000 


3.35% Notes (Continental Pipe Line Company) 






Payable $450,000 Annually Commencing 1956 . 


7,500,000 


7,500,000 


Purchasing Obligations 


633,233 


884,259 




$108,133,233 


$ 53,384,259 


Deferred Federal Income Taxes 


$ 2,350,000 


$ 473,815 


Reserves for Insurance and Annuities 


$ 


$ 343,380 






Stockholders' Equity: 






Capital Stock, Par Value $5 Per Share: 






Authorized-12,000,000 Shares 






Outstanding-9,746,916 Shares in 1954 and 






9,736,916 Shares in 1953 






( Notes 3 and 4 ) 


$ 48,734,580 


$ 48,684,580 


Capital Surplus (Note 3) . 


57,236,462 


57,045,962 


Earned Surplus, Per Accompanying Statement . . 


204,099,036 


187,756,955 




$310,070,078 


$293,487,497 




$480,199,426 


$409,422,917 



attached as Exhibit 3.Mn April, 1955, one session at the company's 
annual meeting of top management personnel was devoted to a dis- 
cussion of the proposed new procedures. Certain of the charts and 
tables which were used for explanatory purposes in this discussion 
are shown in Tables 1 to 6, attached. 



1 A few minor alterations have been made in the report to avoid disclosures of con- 
fidential information. 





Barrels Daily 




1954 


1,953 


Net Crude Oil Production 


125,520 

125,479 
835 

8,679 
155,418 


118,896 


Refinery Runs at Own Plants 

For Continental's Account 

By Continental for Others 


114,722 


Crude Oil Processed 

For Continental by Others 

Sales of Refined Products 


16,145 

145,348 







233 



234 



THE ROLE OF FINANCIAL ANALYSIS 



EXHIBIT 2 

Statement of Consolidated Income and Earned Surplus 
For the Years Ended December 31, 1954, and December 31, 



1953 





1954 


1953 


Income : 

Gross operating income 


$500,125,113 

5,299,238 

$505,424,351 

$374,833,916 

11,483,595 

37,282,664 

7,174,653 

1,905,647 

20,330,412 

2,030,275 

8,700,000 

$463,741,162 

$ 41,683,189 

187,756,955 

$229,440,144 

25,341,108 

$204,099,036 


$476 841 887 


Dividends, interest and other income 

Cost, Expenses and Taxes: 

Costs, operating and general expenses 

Taxes, other than income taxes 

Intangible development costs 

Surrendered leases 


3,121,832 
$479,963,719 

$358,859,062 

10,673,679 

28,536,764 

4,868,072 


Depletion 

Depreciation and retirements 

Interest and debt expense 

Federal and state income taxes 

Net Income for Year 


1,809,651 
17,618,753 

1,823,072 

14,900,000 

$439,089,053 

$ 40,874,666 


Earned Surplus: 

Balance at beginning of year 

Dividends paid ( $2.60 per share in each year ) . . . . 


172,197,393 

$213,072,059 

25,315,104 

$187,756,955 



note; 



Continental Oil Company is one of four or five major oil companies which 
charge all intangible drilling costs to income in the year incurred. Many 
other major oil companies follow the practice of capitalizing intangible drill- 
ing costs and amortizing a certain portion of them each year in proportion 
to crude oil produced. 



2. 



EXHiniT 3 

Report to President 
Appraisal of New Capital Investments— Summary 

Beginning July 1, 1955, we should use return on investment figures as the 
primary yardstick for evaluating new^ capital investments in place of the 
years to pay out figures which have been our primary guide in the past. 
Years to pay out figures should also be calculated but should be used only 
as measures of capital turnover. 

Seven per cent per annum after taxes should be regarded as the rate of 
return necessary to cover our average, long-run cost of capital and to 
maintain our earnings per share at about their present level. 

Our stockholders expect continual improvements in their financial returns, 
and we should therefore seek to invest the majority of our capital funds in 



CONTINENTAL OIL COMPANY 235 

situations where it will earn substantially more than 7% after taxes. More- 
over, in accordance with universal financial practices, we should require 
higher rates of return on our money when the risks are high than when the 
risks are low. 

It is recommended, therefore, that the normally expected level of return 
for the general run of investments in marketing and pipeline facilities 
should be about 10% or better; for refining facilities, 14% or better; and for 
development wells and petrochemical facilities, 18% or better. Projects 
showing lower rates of return should be undertaken only when there are 
very sound, nonfinancial justifications for them. 

4. Beginning July 1, 1955, all return on investment figures should be calculated 
by the financial method; that is, on the basis of the investment actually 
outstanding from time to time over the life of the project rather than on the 
basis of the original or average investments which we are now using. 

The chief advantage of the financial method is that it differentiates be- 
tween investments which generate their income early and investments 
which generate their income late. In addition, adoption of the financial 
method would serve to place procedures for calculating returns on a uniform 
basis in all departments of the company. 

5. The financial method of calculating returns should be applied in the various 
departments of the company in accordance with the general methods illus- 
trated in Exhibits 6 to 9 of this memorandum. 

6. In order to insure that proper consideration will be given to the possibility 
of selling some of our existing service stations and replacing them with new 
stations elsewhere, it is recommended that any funds realized from such 
sales (after deducting applicable capital gains taxes) should be made avail- 
able automatically as an addition to the service station building budget of 
the division arranging the sale. 

7. Wherever it is feasible to do so, accounting and statistical procedures should 
be developed which will make it possible to compare the actual earnings of 
new investments against those projected at the time the investment is made. 
These comparisons should be summarized by divisions, regions, and func- 
tional areas and reported to top management on a continuing basis. 

8. If the recommendations contained in this memorandum are accepted, a 
Working Committee on Investment Analysis should be established. This 
group should develop the detailed plans and instructions for implementing 
the new procedures in the various departments, visit the region and division 
offices to discuss the new methods with the field personnel, and have the 
responsibility for establishing during the coming year the follow-up pro- 
cedures outlined in recommendation 7. 

Signed: 



236 THE ROLE OF FINANCIAL ANALYSIS 

EXHIBIT 4 

Appraisal of New Capital Investments— February 9, 1955 

Continental is currently investing new money in the oil business at the rate 
of about $100 million per annum, or $385,000 each working day. The manage- 
ment judgment which is exercised in the making of these investments has a 
very significant bearing on current and future earnings per share and a profound 
influence on the long-term growth and development of the company. It is, 
therefore, of utmost importance that we develop the best possible yardsticks 
for comparing one investment opportunity against another and for evaluating 
the return which particular projects will earn on the stockholder's dollar. 

The purpose of this memorandum is to present a series of recommendations 
which are designed: (a) to provide a more accurate means of discriminating 
among new investment opportunities than we now have, (b) to establish 
reasonable uniformity among the procedures used for the appraisal of new 
investments in different departments of the company, and (c) to provide a 
simple means of determining how particular projects will affect our future 
earnings per shai'e. 

The memorandum is divided into three parts. Part I contains the recom- 
mendations and a brief explanation of the reasons for them. Part II contains 
various examples and explanatory .notes. Part III contains detailed instructions 
for the use of the procedures recommended herein.* 



I. Recommendations 

A. Use of Return on Invesfmenf os Primary Yardstick: 

For the past several years, it has been our practice to measure new capital 
investments by means of two figures: (a) years to pay out, and (b) return on 
investment. Ordinarily, however, emphasis has been placed on the years to pay 
out figure and relatively little attention has been given to the rate of return. 

Beginning July 1, 1955, it is recommended that we reverse the order of 
significance attached to these two figures and use return on investment as the 
primary yardstick for evaluating new capital investments. We should continue 
to calculate years to pay out figures but should use them only as measures 
of capital turnover and not as measures of the relative value of particular in- 
vestments to the company. 

The reasons for de-emphasizing years to pay out figures in the analysis of 
new investments may be summarized as follows: 

1. Years to pay out figures do not provide an adequate means of discriminat- 
ing among new investment opportunities because they indicate onlv the 
length of time necessary to recover the original capital outlav. Actually, 
the true worth of an investment depends upon how long it will continue 
to produce income after the original outlay has been recovered. As a 
result, years to pay out figures are reliable measures of the relative worth 
of alternative investments only when the income producing life of all 
projects under consideration is about the same. 

' This part of the memorandum has not been included in the case. 



CONTINENTAL OIL COMPANY 237 

When the income producing life of two or more projects is different, 
as is often the case in Continental's situation, comparisons by means of 
years to pay out figures may be grossly misleading. As shown in Schedule 
1, for example, it is entirely possible for a project with a seven-year payout 
and a long life to yield a far better return on the stockholder's dollar than 
a project with a five-year payout and a short life. 

2. Years to pay out figures are also deficient as a yardstick for measuring new 
capital investments because they give no clear indication of whether or 
not the earnings from a particular project will be sufficient to cover our 
long-run cost of capital and to maintain our earnings per share at their 
present level. Under certain circumstances, a project with a five-year 
payout could have the effect of reducing earnings per share, whereas a 
project with a ten-year payout might have the effect of increasing earnings 
per share. 

Return on investment figures provide a much better yardstick for measuring 
new investments because they do not have the two weaknesses noted above. 
Such figures give full recognition to the income produced after the original 
capital outlay has been recovered and make it possible to compare the earnings 
from a project against our long-run cost of capital and the minimum return 
necessary to maintain our earnings per share. 

B. Rate of Return Necessary to Cover Cost of Capital: 

On the basis of past experience, it appears that Continental's average, long-run 
cost of capital is somewhere in the neighborhood of 7% per annum after taxes. 
A return of 7% after taxes may therefore be regarded as the "break-even point" 
for new capital investments. Projects earning a lower rate of return will have the 
general effect of reducing our present earnings per share, and it is recommended 
that such ventures be undertaken only when there are very strong nonfinancial 
or operational reasons for them. 

Average cost of capital. The 7% figure for Continental's average cost of capital 
is derived from the following considerations: 

1. The funds which Continental has available for investment are drawn from 
three principal sources: long-term debt, equity capital obtained from the 
sale of common stock, and retained earnings. Over the long run, it may be 
assumed that about 25% of our funds for expansion will come from long- 
term debt and about 75% from the sale of common stock or retained earn- 
ings. 

2. Continental's credit is such that the long-term debt money can probably be 
secured at an average rate of somewhere around 3/2%. Interest charges are 
a deductible expense for tax purposes, and hence the investment funds ob- 
tained from long-term debt may be considered to have an after tax cost of 
about 1/4% (assumes a tax rate of 50%) . 

3. The "cost" of equity capital obtained from the sale of common stock is the 
rate of return which must be earned on the new money in order to avoid a 
dilution in our earnings per share. This required rate of return depends 
upon the relationship between the market price of our stock at the time the 
sale is made and our current earnings per share. Ordinarily, our price- 



238 THE ROLE OF FINANCIAL ANALYSIS 

earnings ratio is such that the required rate of return on new equity money 
is around 7-9% after taxes. 

As may be seen from Schedule 2, for example, if in 1954 we had ob- 
tained $100 milHon from the sale of 1,667,000 shares of new common stock 
at a price of $60,* the new funds would have had to be invested in such a 
manner as to earn $7.1 million or 7.1% per annum after taxes in order to 
maintain our earnings per share at their 1954 level. 

4. Retained earnings are similar to equity capital, except that they represent 
an involuntary rather than a voluntary new investment by stockholders. 
It may therefore be assumed that they also have an average "cost" of 
about 7-9% after taxes. Alternatively, it might be said that our stockholders 
expect each $1 of earnings retained by management to be put to work 
in such a way that ultimately the market price of Continental's stock will 
increase at least $1. All other things being equal, however, this will not 
happen unless the money is so invested that it earns a return at least 
equal to the present ratio of our earnings to the market price of our stock, 
or about 7-9%. 

5. If long-term debt money has an after tax cost of 1/4% and equity capital 
and retained earnings an after tax cost of 7-9%, we may assume that the 
weighted average cost of the funds Continental has available for new 
investments is in the neighborhood of 7%. This average assumes, as noted 
above, that we will obtain about 25% of our money from long-term debt 
and the remainder from equity stock and retained earnings. 

The 7% figure should be used as a bench mark in evaluating all new invest- 
ments, regardless of whether the particular project at hand is being financed 
by borrowings, the sale of new stock, retained earnings, or some mixture of the 
three.** To the extent that we use our low-cost debt money for one project, v/e 
will not have it available for the next project, because we probably cannot ex- 
pect to draw more than about 25% of our funds for new ventures from the debt 
source. The only sound procedure, therefore, is to consider that all new projects 
are financed from a common pool of investment funds and that the monies 
flowing into that pool have a long-run, average cost of about 7% after taxes. 

C. Normally Expecfed Level of Return on New Investments: 

If Continental is to grow and expand on a profitable basis, it is, of course, 
necessary that our new investments earn substantially more than the 7% mini- 
mum necessary to cover our long-run average cost of capital. Moreover, in 
keeping with universal financial practices, we should require higher rates of 
return on our money when the risks are high than we do when the risks ai'e low. 

It is recommended, therefore, that the normally expected level of return for 
the general run of investments in mai'keting and pipeline * * * facilities should be 



* The price range for Continental stock in 1954 was between $52 and $75 per share. 

** A somewhat different standard may be appropriate in the case of investments in 
or hy subsidiary or affiliated companies which have a very low ratio of equity to debt 
capital. 

*** For this purpose, the pipeline calculations should include pipeline earnings plus 
transportation savings to Continental. 



CONTINENTAL OIL COMPANY 239 

about 10% or better; for refining facilities, 14% or better; and for development 
wells and petrochemical facilities, 18% or better.* 

From time to time, there will be sound operational reasons for undertaking 
projects which offer lower rates of return. It should be recognized, however, 
that such ventures are subnormal in terms of the contribution they will make 
to the financial growth and development of the company, and we should make 
certain that they are well-warranted by the circumstances at hand. As noted 
earlier, particularly strong justification should be required for any project which 
shows a return below the "break-even level" of 7% after taxes. 

D. Need for Uniform Procedures in All Deportments: 

In order that the top management group may have the same yardstick for the 
measurement of investment opportunities in all departments of the company, 
it is necessary that all departments follow the same general procedures in the 
calculation of their return on investment figures. Some of the discrepancies in 
our existing practices and recommendations for correction of them are outlined 
below: 

1. At the present time, return on investment figures in the Marketing De- 
partment are based on average investments, whereas in all other depart- 
ments of the company they are based on original investments. In other 
words, we are now using two completely different yardsticks to measure 
our capital investments and the figures obtained by one procedure can be 
as much as twice as great as those obtained by the other. 

Both procedures are commonly used in the business world, but there 
is no justification, theoretical or practical, for using a mixture of the two 
procedures in the same company. The recommended solution is a com- 
promise between the two methods, as outlined in paragraph E below. 

2. The income from marketing investments is now being estimated on the 
basis of fairly long-term average spreads between tank wagon and tank 
car prices. The income from refining investments, however, is usually 
based on the current spread between crude oil and tank car prices at the 
time the calculation is made. 

As a result, the two procedures are not consistent, and the refining pay- 
outs may sometimes incorporate part of the marketing "profits" or may 
sometimes fail to take all of the profits properly attributable to them. 
Moreover, since the refining margin fluctuates so widely from month to 
month, a project could look good or bad under the existing procedure 
depending on the particular month in which it was calculated. 

It is recommended, therefore, that refinery returns and payouts be 
calculated on the basis of average tank car prices in the same general 
manner as that used in the marketing calculations. 

3. The procedures used in the Manufacturing and Pipeline Departments 
are designed to reflect any financial advantages secured from fast tax 
write-offs. The procedures used in the Production Department, on the 
other hand, do not reflect fully the tax deductions gained from the ex- 
pensing of intangible drifling costs in the first year of development. 



* These suggested standards may require some adjustment after we ha\ e had a 
little experience with the new procedures. 



240 THE ROLE OF FINANCIAL ANALYSIS 

In order that our return on investment and payout figures may be as 
realistic as possible, it is recommended that procedures in all departments 
be designed to reflect (in so far as practical) the actual tax status of each 
investment. 



E. Use of Financial Method fo Colculafe Returns: 

It is recommended that beginning July 1, 1955, all return on investment fig- 
ures be calculated by the financial (or discounted cash flow) method. Under this 
procedure, which is universally used by banks and other lending institutions, 
the return is computed on the investment actually outstanding from time to 
time over the life of the venture rather than on the original or average invest- 
ments. The financial method is slightly more complicated than the procedures 
we are now using, but it offers two major advantages: 

1. The financial method gives the true rate of return on the investment. Both 
the original and average investment methods which we ai'e now using 
provide only an approximation of the true rate of return. The original 
investment method usually understates the return, and the average in- 
vestment method usually overstates the return. Moreover, the amount 
of over- or understatement is not always uniform, so there is no easy way 
of making mental allowance for it. Depending on the circumstances, the 
true rate of return could be as much as double or as little as half that 
calculated by our existing procedures (see examples in Schedules 3 to 5). 

2. The financial method makes due allowance for differences in the time 
at which investments generate their income. In other words, it discrimi- 
nates among investments that have (a) a low initial income which gradu- 
ally increases, (b) a high initial income which gradually declines, and 
(c) a uniform income throughout their lives. Our existing procedures, 
on the other hand, make no allowance for the time which the income is 
received and give exactly the same results for each of the three cases 
(see examples in Schedules 3 to 5). ,• 



[Paragraphs F, G, and H discuss how the financial method would be 
applied in Continental's particular situation to new investments in 
service stations, producing wells, and various other properties. In the 
interests of brevity, they have been omitted from the case.] 

/. Follow-up Procedures: 

Wherever it is feasible to do so, accounting and statistical procedures should 
be developed which will make it possible to compare the actual earnings on 
new investments against those projected at the time the investments are made. 
These comparisons should be summarized by divisions, regions, and functional 
areas, and reported to top management on a regular basis. Continuing compari- 
sons of this type will provide one very important means by which management 
at all levels can gradually improve its judgment in forecasting returns from 
new capital outlays. 



CONTINENTAL OIL COMPANY 241 

J. Working Committee on Investment Analysis: 

If the foregoing recommendations are approved, it is suggested that a Work- 
ing Committee on Investment Analysis be estabHshed. This group, which should 
include a representative from each of the major operating departments, should 
be given three assignments: 

1. The group should develop the detailed plans for implementing the above 
procedures in each department. These plans, after approval by the 
Controller, should be incorporated in Controller's Bulletins and issued to 
the region and division offices by June 1, 1955. 

2. One or more members of the group should visit each of the division and 
region offices during June to explain the new procedures and to make sure 
that both the mechanics and theory of the changes are thoroughly under- 
stood and accepted by the field personnel. 

3. On the basis of the discussions with the field personnel in June, the 
Working Committee on Investment Analysis should make further 
improvements in the details of the procedures. In addition, the group 
should have the responsibility for establishing during the coming year the 
procedures for checking results against estimates as outlined in para- 
graph I above. 

Signed: 



242 



THE ROLE OF FINANCIAL ANALYSIS 



II. Examples and Explanatory Notes 

SCHEDULE 1 

Appraisal of New Capital Investments 
Comparison of Two Investments with Different Lengths of Life 



Project A 



Project B 



Original investment 

Estimated life 

Annual income, after taxes before depreciation 

Depreciation 

Annual income, after taxes and depreciation . . 

Years to pay out 

Return on average investment 



$50,000 
8 years 

$10,000 

6,250 

$ 3,750 

5.0 years 

157. 



$50,000 
25 years 

$ 7,000 

2,000 

$ 5,000 

7.1 years 

20% 



note: In this situation, Project B has the longer payout period, but yields a higher 
return on the stockholder's investment than does Project A. 



SCHEDULE 2 

Appraisal of New Capital Investments 
Illustration of Cost of Equity Capital 

The following calculations demonstrate that if Continental had obtained 
$100 million from the sale of 1,667,000 shares of new common stock in 1954 
at a price of $60 per share, the money would have had to be invested in such 
a manner as to earn $7.1 million or 7.1% per annum after taxes in order to 
maintain our earnings per share at their 1954 level. 





At Present 


After Stock Sale 


Common shares outstanding 

1954 earnings after taxes 

Earnings required on new money after taxes . . 


9,747,000 
$41.7 million 


11,414,000 
$41.7 million 
$ 7.1 million 


Net available for common stock 

Earnings per share 


$41.7 million 

$4.28 


$48.8 million 
$4.28 







„ ^ .1 $7.1 million ^ .^ 

Return required on new money— = 7.1% per annum 

^ ^ $100 million ^ 

$4 '^8 
Ratio of per share earnings to stock price ' = 7.1% 

^ ^ ^ $60 



CONTINENTAL OIL COMPANY 



243 



srHEDiTi.v: tt 

Appraisal of New Capital Investments 
Comparison of Methods: Investments v/ith Uniform Income 

Assumptions: 

Original investment $ 56,502 

Annual income, after taxes before depreciation $ 10,000 

Life of investment 10 years 

Total income $100,000 

Total profit after return of original investment $ 43,498 

1. Return Based on Original Investment: 

Annual income, after taxes before depreciation $ 10,000 

Deduct: depreciation ( $56,502 ^ 10 years) 5,650 

Annual income after taxes and depreciation $ 4,350 

Return on investment i I = 7.7% 

$56,502 

2. Return Based on Average Investment: 

Annual income, after taxes before depreciation $ 10,000 

Deduct: depreciation ( $56,502 -^ 10 years) 5,650 

Annual income after taxes and depreciation $ 4,350 

Return on investment ^ ^'^^^ = 15.4% 

$28,251 

3. Return Calculated by Financial Method: 12% 

Discount Present 

Years Income Factor— 12% Value 

1st to 10th $10,000 5.6502 $56,502 (equals investment) 

Verification of 12% Return: 

Balance of Principal 
Year Income Interest at 12% Return of Principal at Beginning of Year 

1st $ 10,000 $ 6,780 $ 3,220 $56,502 

2nd 10,000 6,394 3,606 53,282 

3rd 10,000 5,961 4,039 49,676 

4th 10,000 5,476 4,524 45,637 

5th 10,000 4,934 5,066 41,113 

6th 10,000 4,326 5,674 36,047 

7th 10,000 3,645 6,355 30,373 

8th 10,000 2,882 7,118 24,018 

9th 10,000 2,028 7,972 16,900 

10th 10,000 1,072 8,928 8,928 

$100,000 $43,498 $56,502 



244 



THE ROLE OF FINANCIAL ANALYSIS 



SCHEDULE 4 



Appraisal of New Capital Investments 
Comparison of Methods: Investments with Declining Income 



Assumptions: . - 

Original investment 

Annual income, after taxes before depreciation 



. . $ 56,502 

$ 15,000 1st to 3rd yrs. 
$ 10,000 4th to 7th yrs. 
' $ 5,000 8th to 10th yrs. 
Life of investment 10 years 



Total mcome 

Total profit after return of original investment . 

Return Based on Original Investment: 

Average annual income, after taxes before 

depreciation 

Deduct: depreciation ($56,502 -^ 10 years) . . . 

Annual income after taxes and depreciation . . 

15 , • , ^ $ 4,350 
Return on investment I I 

$56,520 
Return Based an Average Investment: 

Average annual income, after taxes before 

depreciation 

Deduct: depreciation ($56,502^10 years) .. 
Annual income after taxes and depreciation . . 

$ 4,350 
$28,251 



Return on investment 



3. Return Calculated by Financial Method: 

Discount 
Years Income Factor— 15.5% 

1st to 3rd $15,000 2.2644 

4th to 7th 10,000 1.8343 

8th to 10th 5,000 .8258 

Verification of 15.5% Return: 



$100,000 
$ 43,498 



$ 10,000 

5,650 

$ 4,350 



$ 10,000 

5,650 

$ 4,350 



15.4% 
15.5% 



Year 


Income 


Interest at 1 


1st 


$ 15,000 


$ 8,758 


2nd 


15,000 


7,841 


3rd 


15,000 


6,681 


4th 


10,000 


5,391 


5th 


10,000 


4,677 


6th 


10,000 


3,852 


7th 


10,000 


2,899 


8th 


5,000 


1,798 


9th 


5,000 


1,302 


10th 


5,000 


729 




$100,000 


$43,928 



Present 
Value 

$33,966 
18,343 
4,129 
$56,438 ( equals investment ) 

Return of Balance of Principal 

Principal at Beginning of Year 

$ 6,242 $56,502 

7,559 50,260 

8,319 43,101 

4,609 • 34,782 

5,323 30,173 

6,148 24,850 

7,101 18,702 

3,202 11,601 

3,698 8,399 

4,271 4,701 

$56,072 430* 



Does not come to zero because of rounding of numbers. 



CONTINENTAL OIL COMPANY 



245 



SCHEDULE 5 

Appraisal of New Capital Investments 
Comparison of Methods: Investments with Increasing Income 

Assumptions: 

Original investment $ 56,502 

Annual income, after taxes before depreciation $ 6,000 1st to 3rd yrs. 

$ 10,000 4th to 7th yrs. 

$ 14,000 8th to 10th yrs. 

Life of investment 10 years 

Total income $100,000 



Total profit after return of original investment . . 

Return Based on Original Investment: 

Average annual income, after taxes before 

depreciation 

Deduct: depreciation ($56,502-^ 10 years) . . 
Annual income after taxes and depreciation . . 

$ 4,350 
$56,502 



$ 43,498 



10,000 
5,650 
4,350 



Return on investment 



Return Based on Average Investment: 

Average annual income, after taxes before 

depreciation 

Deduct: depreciation ($56,502 -^ 10 years) 

Annual income after taxes and depreciation 

Return on investment I = 

$28,251 

Return Calculated by Financial Method: 

Discount Present 

Years Income Factor— 10% Value 



7.7% 



$ 10,000 

5,650 

$ 4,350 

15.4% 



10+% 



1st to 3rd $ 6,000 


2.4869 


$14,921 




4th to 7th 10,000 


2.3816 


23,816 




8th to 10th 14,000 


1.2761 


17,866 










$56,603 ( equals investment ) 


Verification of 10+% Return: 












Return of 


Balance of Principal 


Year 


Income j 


Interest at 10% 


Principal 


at Beginning of Year 


1st 


$ 6,000 


$ 5,650 


$ 350 


$56,502 


2nd 


6,000 


5,615 


385 


56,152 


3rd 


6,000 


5,578 


422 


55,767 


4th 


10,000 


5,535 


4,465 


55,345 


5th 


10,000 


5,088 


4,912 


50,880 


6th 


10,000 


4,597 


5,403 


45,968 


7th 


10,000 


4,057 


5,943 


40,565 


8th 


14,000 


3,462 


10,538 


34,622 


9th 


14,000 


2,408 


11,592 


24,084 


10th 


14,000 


1,249 


12,751 


12,492 




$100,000 


$43,239 


$56,761 


259* 



* Does not come to zero because of rounding of numbers. 



246 THE ROLE OF FINANCIAL ANALYSIS 

TABLE 1 

Sources and Costs of Funds for Capitol Investment 

Sources of Funds for Capital Investment: 

1. Long-term borrowing 25% 

2. Sale of common stock ) j^^ 

3. Retained earnings j 

Cost of Borrowed Money: . . 

3%-4% before taxes 

l)^%-2% after taxes ' ' ' .- 

Return Required on Money Obtained from Sale of Common Stock: 

Assume $100 million obtained from sale of new common stock at price of 
$60 per share. 

Number of shares sold ' ^ ' = 1,667,000 shares 

$60 

Required earnings to break even 

$4.28 per share X 1,667,000 = 7,100,000 

Required rate of return on new investments 

$7,100,000 



$100,000,000 



=2 7.1% per annum after taxes 



Return Required on Retained Earnings: 



1954 Earnings per Share „ _ 

^ ^ -% Return 



Pure 



Recent Market Prices Per Share 
$7.09 



$80 



$4.40 
Shell |g^ =7.1 

$5.15 
Socony j^^ =9.6 

Sun ^^^3- =5.8 

^5.82 
Ohio Oil ^y^ = 8.2 



CONTINENTAL OIL COMPANY 



247 



TABLE 2 

Payout Periods as a Measure of New Investments 

ANNUAL INCOME 



$40 








2 30 








z 








< 






<n 


♦, 


\ ^ 




8 20 


*. 


V 


^s. 


X 


:a 


\b 


^s^ 


10 
o 


: 


V 

\ 


X 



10 15 

YEARS 



25 





Project A 


Project B 


Project C 


Original investment 

Life of investment 


$125,000 
10 years 

5 years 

12% 


$125,000 
15 years 

5 years 

18% 


$125,000 
25 years 

5 years 

20% 


P.yn„. p.HnH $125,000 _ 


^ "■ $ 25,000 
Return on investment 



TABLE 3 

Methods of Calculating Return on Investment Figures 

1. Original Investment Method: 

Divide average annual income after taxes and depreciation by the total original 
capital outlay. 

Used by our Production, Manufacturing, Petrochemical and Pipe Line 
Departments. 

2. Average Investment Method: 

Divide average annual income after taxes and depreciation by half the original 
investment or by whatever figure represents the midpoint between the original 
cost and the residual value of the property at the end of its life. 

Used by our Marketing Department. 

3. Financial Method: 

Calculate return on the basis of the investment actually outstanding from time 
to time over the life of the project. 

Used by our Financial Department, our banks, and other financial institutions. 



248 



THE ROLE OF FINANCIAL ANALYSIS 



TABLE 4 

Comparisons of Return on Investment Calculations 

ANNUAL INCOME 



$40 



20 



B 


■;:>->. 






..-•'c 






^> 



10 15 

YEARS 



20 



25 



Project A 



Project B 



Project C 



Original investment 

Life of investment 

Total income, after taxes before depre- 
ciation 

Average annual income, after taxes be- 
fore depreciation 

Deduct depreciation ($125,000 -^ 25 
years ) 

Annual income after taxes and deprecia- 
tion 

Return on original investment 
$ 15,000 



$125,000 

Return on average investment 
$15,000 



$62,500 
Return by financial method 



$125,000 
25 years 

$500,000 

$ 20,000 

$ 5,000 

$ 15,000 

12% 

24% 
24% 



$125,000 
25 years 

$500,000 

$ 20,000 

$ 5,000 

$ 15,000 

12% 

24% 
15.5% 



$125,000 
25 years 

$500,000 

$ 20,000 

$ 5,000 

$ 15,000 



24% 
13% 



CONTINENTAL OIL COMPANY 



249 



TABLE 5 

Application of Financial Method to Investments with Uniform Income 

$30 I 



CO 

o 

z 20 

en 

O 10 

X 



ANNUAL INCOME 



10 15 

YEARS 



20 



25 



Original investment $93,500 

Life of project 15 years 

Average annual income, after taxes before depreciation $20,000 

Payout period ^^^'^^^ = 4.68 years 

$20,000 ^ 

Return on investment 20% 



DISCOUNT TABLE 



Life of Project 


Percentage Return 














18% 


19% 


20% 


21% 


22% 


1 year 


.847 


.840 


.833 


.826 


.820 


2 years 


1.566 


1.547 


1.528 


1.509 


1.492 


3 years 


2.174 


2.140 


2.106 


2.074 


2.042 


4 years 


2.690 


2.639 


2.589 


2.540 


2.494 


5 years 


3.127 


3.058 


2.991 


2.926 


2.864 


6 years 


3.498 


3.410 


3.326 


3.245 


3.167 


7 years 


3.812 


3.706 


3.605 


3.508 


3.416 


8 years 


4.078 


3.954 


3.837 


3.726 


3.619 


9 years 


4.301 


4.163 


4.031 


3.905 


3.786 


10 years 


4.490 


4.339 


4.192 


4.066 


3.923 


11 years 


4.650 


4.487 


4.327 


4.189 


4.035 


12 years 


4.786 


4.611 


4.439 


4.290 


4.127 


13 years 


4.901 


4.715 


4.533 


4.374 


4.203 


14 years 


4.998 


4.802 


4.611 


4.444 


4.265 


15 years 


5.081 


4.876 


4.675 


4.501 


4.315 



250 



THE ROLE OF FINANCIAL ANALYSIS 



TABLE 6 

Illustration of Return Calculated by Financial Method 



$20 
10 







EARNINGS ^ ' 

__,^^ *-^" REPA YM E NT 





to i 






3 

o 


80 




X 






H- 






•^ 




60 


t ^^""^^ 




40 




^^ 






INVESTMENT ^V. 




20 


1 ^ 



10 15 

YEARS 



20 



25 





A7inual 


Repayment of 


Available for 


Investment 


Return on 


Year 


Income 


Investment 


Earnings 


Outstanding 


Investment 


1 


$ 20,000 


$ 1,298 


$ 18,702 


$93,510 


20% 


2 


20,000 


1,558 


18,442 


92,212 


20 


3 


20,000 


1,869 


18,131 


90,654 


20 


4 


20,000 


2,243 


17,757 


88,785 


20 


5 


20,000 


2,692 


17,308 


86,542 


20 


6 


20,000 


3,230 


16,770 


83,850 


20 


7 


20,000 


3,876 


16,124 


80,620 


20 


8 


20,000 


4,651 


15,349 


76,744 


20 


9 


20,000 


5,581 


14,419 


72,093 


20 


10 


20,000 


6,698 


13,302 


66,512 


20 


11 


20,000 


8,037 


11,963 


59,814 


20 


12 


20,000 


9,645 


10,355 


51,777 


20 


13 


20,000 


11,574 


8,426 


42,132 


20 


14 


20,000 


13,888 


6,112 


30,558 


20 


15 


20,000 


16,670 


3,330 


16,670 


20 




$300,000 


$93,510 


$206,490 








ease 



26 



VELOX OIL COMPANY 

Capital Investments 

The Velox case Involves, among other things, the problem of ap- 
praising the results of past capital expenditures as an aid to making 
future decisions in that area. It requires careful analysis of figure 
information to insure that the decision is based on consideration of 
relevant data. Questions of incremental costs and revenues are 
raised as they relate to capital investments at different stages of 
the production and distribution processes of an integrated oil 
company. 

Introduction 

In 1948 the Velox Oil Company of California began a program 
of investment in the modernization and expansion of its gasoline 
marketing facilities. About 90% of the outlay was for building and 
rebuilding gasoline service stations. From an initial commitment of 
$1.9 million in 1948, the annual expenditure on the program grew to 
just over $4.3 million in 1951, and approximately this amount was 
spent each year through 1954. Exhibit 1 shows the annual amount 
spent on the program and the number of new, rebuilt and leased 
stations added each year. The leased stations were built by Velox, 
sold, and leased back. Early in December, 1954, after almost seven 
years of investment in the modernization and expansion program, 
the company's president was considering whether to recommend to 
the board of directors in his proposed 1955 capital budget the con- 
tinuance of investment in marketing facilities at the rate of just 
under $4.5 million a year. 

Present Marketing Program 

The Velox Oil Company owned and operated several refineries at 
points throughout its West Coast marketing area and distributed 
the output of these refineries through three main channels which 
were designated ( 1 ) "general office," ( 2 ) "branded jobbers," and 
(3) "bulk plant-service station." To supplement the output of its 

251 



252 



THE ROLE OF FINANCIAL ANALYSIS 



EXHIBIT I 

Data on Marketing Facilities for Years 1948-1954 





Total Annual 


Number of 








New 


Service 




Total 


Year 


Investment 


Stations Added 


Old Stations 

at the End of 

the Year 


Stations 


in Marketing 


During the Year 


at the End of 




Facilities— 


New, Rebuilt, 


the Year 




in Millions 


or Leased 






1948 


1.9 


9 


338 


347 


1949 


2.8 


19 


329 


357 


1950 


3.6 


84 


302 


414 


1951 


4.3 


80 


286 


478 


1952 


4.4 


107 


268 


567 


1953 


4.4 


90 


249 


638 


1954 (est.) 


4.2 


109 


224 


722 



note: When an old station is rebuilt, or when it goes out of business, it is sub- 
tracted from the list of old stations at the end of the year. 



source: Company records. "' 

own refineries, the company bought gasohne from other companies 
for distribution through the bulk plant-service station channel. In 
1953, the last complete year on record, the company sold 450 million 
gallons through the general office channel, 175 million gallons 
through branded jobbers, and 235 million gallons through the bulk 
plant-service station channel (see Exhibit 2). Motor gasoline made 
up 38% of the general office volume, 59% of the branded jobber 
volume, and 86% of the volume handled by the bulk plant-service 
station channel. 

Sales through the general office channel included large lot sales 
of unbranded gasoline, oil, and distillates, sometimes by yearly 
contract, to customers who picked up the refinery output in pipe- 
lines, tankers, or tank cars at or near the refinery gate. The price 
received depended largely on the conditions of supply and demand 
at the refinery location at the time of purchase agreement. Distribu- 
tion through the general office channel involved practically no in- 
vestment in marketing facilities and very little selling expense. 

All the gasoline distributed through the jobber and bulk plant- 
service station channels was sold under the Velox brand name. 
Velox's marketing investment underlying sales to the jobbers con- 



VELOX OIL COMPANY 253 

sisted only of a share of the company's terminal facilities since the 
jobbers provided their own bulk plants and other retail outlets. 
Selling expense per gallon in the jobber channel was a small amount 
arrived at through allocations from total marketing expense made by 
sales division managers. On the other hand, in the bulk plant-service 
station channel most of the gasoline moved through company-owned 
facilities. In this channel, the gasoline was carried first to a terminal, 
and then to a bulk plant from which it was distributed to company- 
owned service stations (43% of the gallonage), to independent 
service stations using the Velox brand name (33%), and direct to 
farmers, commercial users, and fleet operators (24%). Almost all 
the bulk plants were owned by Velox, but only a small number were 
operated by company employees; the majority were run by agents 
who were paid a commission for each gallon they handled. Most of 
the stations built since 1948 were equipped with sufficient storage 
so that they could be supplied directly from terminals. In such cases, 
where the bulk plant was by-passed, an override commission of 
about one-half cent per gallon was still paid to the bulk plant agent. 

Most of Velox's investment in marketing facilities was in the bulk 
plant-service station channel, and in that channel service stations 
accounted for the largest part. The 1953 budget commitments of 
$4.4 million were divided roughly as follows: 90% to service stations, 
4% to bulk plant and terminal facilities used to supply the bulk 
plant-service station channel, 1% to terminals used in the jobber 
channel, and 5% to miscellaneous small projects mostly concerned 
with administrative facilities. At the end of 1953 the net investment 
(cost less reserve for depreciation) stood at $17.1 million in the bulk 
plant-service station channel, including about $5.1 million in service 
station sites, $11.4 million in service stations, and $.6 million in bulk 
plants and terminals supplying the bulk plant-service station chan- 
nel. The jobber channel was supported by a net investment of about 
$.2 million. 

The manufacturing (refinery) investment supporting each mar- 
keting channel was difficult to segregate, since each refinery's output 
was distributed through all three channels. An allocation of manu- 
facturing investment to the three channels on the basis of volume 
would not be realistic, since high value products (motor gasoline) 
required more refinery facilities than the low value products (fuel 



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254 



VELOX OIL COMPANY 755 

oil or distillates), and the bulk plant-service station channel distrib- 
uted a higher proportion of high value products than either of the 
other two channels. A rough approximation could be obtained, how- 
ever, by allocating the $19.2 milhon total net manufacturing invest- 
ment at the end of 1953 according to the value of products 
distributed during the year. This allocation indicated that each gallon 
of refinery output distributed through the general office channel in 
1953 was supported by $.0211 of refinery investment, each gallon 
distributed through the jobber channel by $.0217, and each gallon 
distributed through the bulk plant-service station channel by $.0251 
of investment. By this system $9.5 million was allocated to the gen- 
eral office channel, $3.8 million to the branded jobber channel, and 
$5.9 million to the bulk plant-service station channel. 

Formation of Capital Budget 

The proposed budget for the marketing department was an ac- 
cumulation of projects, individually approved by regional managers 
and each supported by projected income estimates and pay-back 
calculations. The maximum pay-back period acceptable to the com- 
pany was nine years. In terms of return on average investment this 
was equal to about 15% after taxes and after depreciation, based on 
a 25-year life.^ This figure was designed to provide incremental in- 
come over the 7% rate which management estimated as the com- 
pany's cost of capital over the long run. 

The estimated return on a proposed gasoline station project, either 
new or rebuilt, was based on an estimated "normal" volume which 
that station could be expected to achieve and on an approximate 
per gallon market spread ( see below ) . The calculation of each pro- 
posed station's "normal" volume was based on a combination of 
factors such as traffic, location, and frontage on the street or highway. 
The management thought that it would usually take a station five 
years to achieve its normal volume, starting at about 25% of normal 
the first year, increasing to about 40%,, 60%,, 75%,, and 100%, of 
normal during the second, third, fourth, and fifth years. On this basis, 
the return on investment calculations used a volume figure of 60% 
of normal for each of the first five years, and normal volume there- 



1 Since land was not depreciable, depreciation was based on about 70% of the 
original investment. 



256 THE ROLE OF FINANCIAL ANALYSIS 

after for the life of the station, which was estimated to be twenty-five 
years. 

The market spread or gross margin used in calculating the esti- 
mated income on each service station project was calculated for 
each locality in Velox's marketing area; it was the difference between 
the average selling price and the average tank car price as recorded 
over the past two years. The tank car price was the price in each 
locality at which independent bulk plants bought their gasoline. 

When the marketing budget was submitted to the board of di- 
rectors for approval, the individual investment projects were organ- 
ized into classes of projects such as service station sites, service sta- 
tion construction, bulk plant construction, etc. After the board's ap- 
proval of the total for each class, each of the regional managers was 
allocated an amount of money to be spent on the various classes of 
projects; within this amount the regional managers could approve 
any station whose projected pay-back was eight years or less. Sta- 
tions whose pay-back periods were over eight years could be recom- 
mended by the regional manager, but required specific approval by 
either the executive management group or by the marketing vice- 
president to whom the regional managers reported; such stations, if 
approved, were then included in the regional manager's budget. 
These exceptions were permitted if there were other overriding 
reasons for going ahead with a project. For instance, a new gasoline 
station with a nine-year pay-back might be approved if its strategic 
location or elaborate design were believed to provide desirable pro- 
m_otional benefits beyond those which would accrue to the particu- 
lar station involved. 

Characteristics of the Gasoline Market 

In the process of expanding the bulk plant-service station channel 
certain characteristics of the gasoline market emerged. It became 
clear that accurate predictions of service station volume were diffi- 
cult to make since many unpredictable circumstances could cause 
a poor showing in gasoline sales by a service station. For example, 
one station was built next to a new housing development with only 
one competitive station in the area. After a year of satisfactory sales 
two other stations were built by competitors within a block of the 
Velox location, and thereafter Velox's station sold onlv about two- 



VELOX OIL COMPANY 257 

thirds of its predicted volume. Other instances occurred in which 
in-town stations suffered from the population movement to the 
suburbs. This was a continuing problem, not easily solved. On one 
occasion in order to take advantage of this shift, the company traded 
an in-town station for two sites on the edge of town, and though this 
increased the total gasoline sales in the area, neither of the new sta- 
tions sold as much gasoline as had the one in-town station. 

The opinion was expressed by a member of Velox's marketing de- 
partment that different returns should be required of different parts 
of the oil business. A good oil well might pay off in a few months, a 
refinery in a couple of years, but it took many years to develop a 
market for a company's brand of gasoline. In addition some Velox 
executives thought that, although the general office channel might pay 
a higher return on invested capital than the service station channel, 
the company would be in a vulnerable position if sales were made 
only through the general office channel. This channel, they pointed 
out, was very profitable when gasoline was in short supply, but in 
periods of over supply, prices could fall to unprofitable levels. Cus- 
tomers were thought to be least loyal in the general office channel, 
and most loyal in the service station channel. One man compared 
the service station channel with an investment in bonds, the branded 
jobber with preferred stock, and the general office channel with a 
speculative investment in common stock. 

Gasoline Station Sales Volume 

Each year in October and November, the marketing department 
compiled the records of sales volume for the preceding twelve 
months through September 30 for each of the company's service 
stations, and compared them with the normal volume for each sta- 
tion as previously defined. A condensation of the reports for the 
past four years covering service stations built since 1948 appears in 
Exhibit 3. 

The uncondensed reports of station sales volume were summarized 
and interpreted by the controller and by members of the marketing 
department for use by the company's president. The controller's 
comments on the 1954 sales results were as follows : 

Since it is generally conceded that it takes a few years for a new station to 
attain its potential, it was thought advisable to examine the volume records of 



258 THE ROLE OF FINANCIAL ANALYSIS 

stations that had been open two or more years. This study revealed that of the 
128 new stations which had been in operation two or more full years as of 
September 30, 1954, 65 stations, or slightly over one-half of the total, sold less 
during the last twelve months than during the preceding twelve months. 

As of September 30, 1954, 84 rebuilt stations had been in operation two or 
more full years. Here the record was worse because 49 stations, or 58%, sold 
less in the last twelve months than in the preceding twelve months. 

^ EXHIBIT 3 

Gasoline Station Sales Records 
During the Five 12-Month Periods Ending September 30, 1950-1954 

A. Average Sales per Station per Year in Thousands of Gallons 
Station 
Groups * J 950 1951 1952 1953 1954 

1949 243 245 

1950 188 
1951 
1952 
1953 



245 


232 


220 


197 


188 


188 


183 


179 


176 




150 


149 
146 



Total** 4,411 16,266 27,883 40,764 50,187 

B. Average Per Cent of "Normal" *** Volume 

1949 89.6 

1950 

1951 

1952 

1953 



91.3 


95.6 


89.4 


82.9 


77.5 


83.4 


80.2 


80.2 




84.6 


81.8 


81.0 




. 


72.8 


72.4 
74.0 



* Those stations built in the 12 months preceding September 30 of the stated years 1949-1953. Does not 
include stations sold and leased back. 

** Total for all "postwar" stations built since September 30, 1948. 

*** "Normal" volume, as described on page 255 is the volume a station was expected to achieve after 
the five-year lead-in period. 

source: Company records. 



EXHIBIT 4 

Average Volume per Service Station 

Average Number of Gallons per Month 

Sold During the 12 Months Preceding September 30, 1954 

Service stations under one year old on September 30, 1954 12,300 

Service stations one to two years old on September 30, 1954 12,200 

Service stations two to three years old on September 30, 1954 12,400 

Service stations three to four years old on September 30, 1954 14,700 

Service stations four to five years old on September 30, 1954 15,700 

Service stations five to six years old on September 30, 1954 18,300 



source: Company records. 



VELOX OIL COMPANY 



259 



EXHIBIT 5 

Velox Service Station Sales vs. Industry Service Station Sales 

in Velox's Marketing Area 

Percentage Increases in Gallonage from the Previous Year 





Velox 
Service Station Sales 


Industry 
in Same Area * 


1948 

1949 

1950 

1951 

1952 

1953 

1954-First Quarter 

Second Quarter 

First Half 


2.7% 
3.4 
17.4 
18.8 
16.3 
13.5 
13.3 
9.6 
11.3 


8.4% 

8.0 

6.7 

7.0 

2.4 

4.7 

4.7 

4.0 

4.3 



American Petroleum Institute date. 



The marketing department in its report to the president presented 
the figures shown in Exhibit 4, indicating that on the average the 
older the service station the higher the annual sales volume. These 
figures, the report commented, though not conclusive, tended to 
substantiate the slow growth in volume which was thought to be 
characteristic of new stations. 

In addition to reports of annual service station volume, the presi- 
dent had information available concerning Velox's gasoline sales 
volume and that of the whole industry. Exhibits 5, 6, and 7 present 
excerpts from this information. Exhibit 5 compares Velox service 

EXHIBIT 6 

U.S. Consumption of Gasoline and 
Gasoline Stocks 1949-1954 





Consumption of 


Gasoline Stocks- 


Days of Gasoline 




Gasoline— Thousands 


Millions of 


Consumption 




of Barrels per Day 


Barrels 


on Hand 


1949 (Average) 


2,501 


106.2 


42.5 


1950 (Average) 


2,724 


109.4 


40.2 


1951 (Average) 


2,987 


118.0 


39.5 


1952 (Average) 


3,162 


125.1 


39.6 


1953 (Average) 


3,371 


143.1 


42.5 


1954 ( Estimate average ) 


3,393 


155.7 


45.9 



source: Survey of Current Business, IVIarch Issues, and Company Records. 



260 



THE ROLE OF FINANCIAL ANALYSIS 



station sales increases over the past year with similar data for all 
gasoline sales in the Velox marketing area; Exhibit 6 presents figures 
on the consumption of gasoline and the gasoline stocks during the 
last three years; and Exhibit 7 shows some National Petroleum News 
data pertinent to the gasoline service station business. 

The Net Income from Sale of Gasoline 

The net income for each of the three channels was calculated by 
subtracting from the gross sales of that channel the cost of crude oil, 
refining costs allocated by value of refined products, transportation 
costs, and all direct and indirect marketing expenses for the channel. 
In addition there was subtracted from the gross sales of the bulk 
plant-service station channel the cost of gasoline purchased from 
other companies for distribution through that channel. In 1953, 55 
million gallons were bought for the bulk plant-service station chan- 
nel, about one-fifth of which was handled by the company's service 
stations built since 1948. 

In order to evaluate the income from the bulk plant-service station 
channel the controller compared cumulative capital commitments 
for marketing facilities with cumulative cash income after taxes for 
the previous six-year period, including estimated figures for 1954 
( Exhibit 8 ) . The cash income was the difference between total sales 
and the aggregate cost of crude oil plus all refining, transportation, and 

EXHIBIT 7 

Estimates, Forecasts, and Records for U.S. 



Total Gasoline 
Sold Through 
Service Stations 
Millions of Gallons 



Average Total 
Monthly Sales 

Gasoline per 
Service Station 

per Month * 



Number of 

Service 
Stations ** 



Number of 

Passenger 

Cars— 

in Thousands 



Service 

Station 

Building 

Permits 

Issued *** 



1950 
1951 
1952 
1953 
1954 1 



28,522 
30,503 
32,468 
35,501 
37,100 



12,556 
13,495 
14,401 
15,722 
16,316 



189,294 
188,361 
187,877 
188,157 
189,490 



40,167 
42,525 
43,646 
46,245 
47,478 



5,446 
3,092 
3,632 

4,577 
5,899 



* N.P.N. Estimate. 

** Based on Bureau of Census and Bureau of Labor Statistics data. 

*** Based on Bureau of Labor Statistics data. 

t N.P.N. Forecast. 

source: National Petroleum News, June 30, 1954, p. 85. 



VELOX OIL COMPANY 



261 



EXHIBIT 8 

Cumulative Commitments and income 
1949 to 1954-in Millions 





Cumulative 


Cumulative Cash Income 


Cumulative Cash 




Commitments, 


After Taxes 


Income After Taxes 




All Marketing 


Bulk Plant-Service Station 


Bulk Plant-Service 




Facilities 


and Branded Jobber Channels 


Station Channel 


1949 


4.7 


2.1 


1.4 


1950 


8.3 


4.3 


2.9 


1951 


12.6 


6.5 


4.5 


1952 


17.0 


9.7 


7.0 


1953 


21.4 


13.2 


9.6 


1954 (est.) 


24.8 


16.6 


12.6 



source: Company records. 

marketing expenses, except depreciation. The cumulative commit- 
ments included $5.9 million for service stations which were subse- 
quently sold and leased back, and the cumulative income figures 
showed income before deduction of $1.0 million in rental costs. The 
controller presented the yearly cumulative figures in a report to the 
president with the following comments: 

For the six-year period 1949-1954, cash income from bulk plants and service 
stations has been $12.2 million less than the capital commitments of $24.8 
million for marketing facilities. The cash income from the bulk plant-service 
station and branded jobber channels together has been $8.2 million less than 
the capital commitments for marketing facilities. 

It should, of course, be anticipated that cash income would build up more 
slowly than capital commitments, particularly in view of the fact that our 
investment in marketing properties was relatively small at the beginning of the 
six-year period. On the other hand, however, it should be noted that the cash 
income figures used in the Exhibit include the new income attributable to 
manufacturing as well as marketing operations. Moreover, the upward trend in 
cumulative cash income has been so slow relative to that in cumulative capital 
commitments that it may be some years before cash income can catch up with 
capital commitments. 



Conclusion 



Early in December, 1954, the president of Velox Oil Company 
had before him all the information presented in this case. By the 
fifteenth of the month he planned to submit to the board of directors 
the 1955 capital budget, part of which would be for recommended 
expenditures by the marketing department. 



case 



27 



BLACKSTONE MINING COMPANY 

A Problem in Business Investment 

The case raises the question of liquidating an investment in a mining 
property. It focuses on the problem of negotiating a price which will 
be satisfactory to both the Blackstone Company, which owns a 25 
per cent ownership interest, and another corporation, which owns 
the remaining 75 per cent and has indicated an interest in acquiring 
100 per cent ownership in the mining property. 

In March, 1953, the Blackstone Mining Company was considering 
an offer of $600,000 for its holdings of 30 7o of the stock of the Shur- 
cliffe Mining Company which owned and operated a large iron mine. 
The offer had been made by Victor Mines Incorporated which 
owned the remaining 70% of the stock and which was responsible 
for the operating management of Shurcliffe. When the offer was 
made, a meeting had been scheduled between representatives of the 
two companies, where Blackstone's answer would be discussed. 

A vice-president of Blackstone examined the operating records 
of the Shurcliffe Mining Company and made the following com- 
ments: , , 

Victor Mines Inc. has recently expressed interest in acquiring the 30% stock 
interest held by Blackstone. This proposal is of interest to Blackstone because 
(a) the managerial problems associated with the continued participation in the 
mining venture are somewhat burdensome, ( b ) the operating expenses incurred 
by Shurcliffe under the Victor management are regarded as excessive, and (c) 
the Shurcliffe production is declining rapidly and the properties are approach- 
ing the point of economic abandonment. . . . 

Blackstone's production department prepared estimates for the 
future net cash income, after all taxes, which Blackstone could ex- 
pect to derive from Shurcliffe's operations under the present owner- 
ship arrangement. Commenting on the probable pattern of income if 
Blackstone retained 30^, interest, as shown in Table 1, the Black- 
stone vice-president made the following statement: 

If Blackstone retains its 30% stock interest, the Shurcliffe properties will 
probably be operated on the present basis until about 1960. At this point, 

262 



BLACKSTONE MINING COMPANY 263 

assuming no increase in ore prices, the Shurcliffe Mining Company would 
begin to incur operating losses, and the company would, therefore, be 
liquidated. The two owners would pay capital gains taxes at the time of 
liquidation. It may be assumed that thereafter the properties would be operated 
by Victor, with Blackstone retaining a 30% working interest. In 1966, the 
properties and facilities would probably be sold for their salvage value. 

Blackstone's management accepted the estimates of future income 
as accurate, since the company had had long experience with the 
properties, and future rates of ore production could be predicted 
with a considerable degree of assurance. As a matter of fact. Black- 
stone's management felt that it had very few investments whose 
future income could be estimated more reliably. And, though it 
could not be sure, the Blackstone management thought this would 
probably hold true for Victor also. 

The production department also estimated the net cash income 
which Victor would receive if that company owned 100% of the 
Shurcliffe Mining Company ( Table 2 ) . These estimates showed that 
Victor's income from 100% would be more than 3/7 (30%)/70%) 
larger than the present cash income derived from its 70% interest. 
There were three reasons for this additional benefit: (a) Victor 
would be in a position to make certain savings in operating expenses, 

(b) Victor would avoid the intercorporate dividend taxes which it 
was currently paying on the dividends received from Shurcliffe, and 

(c) Victor would avoid payment of the capital gains tax which 
would be levied if Shurcliffe were liquidated as anticipated in 1960. 
Both these tax obligations would be eliminated if Shurcliffe were 
consolidated with Victor, an action possible under the tax laws when 
a stock interest of over 80% is owned. 

Blackstone's officers also noted that, should their company decide 
to sell, it would be subject to the 25% capital gains tax on virtually 
the whole price received, since Blackstone's cost base was very low; 
Victor could avoid this tax by consolidating the Shurcliffe Company, 
and continuing to operate the mine until it was depleted. 

What plan of negotiation would you prepare for the scheduled 
meeting? Your plan should consider the minimum price you would 
accept and an estimate of the maximum that might be expected. 



264 



THE ROLE OF FINANCIAL ANALYSIS 



TABLE 1 

Blackstone's Cash Income from Shurcliffe After All Taxes 
if 30% Stock Interest Is Retained 

1953 $ 94,716 

1954 162,343 

1955 133,297 

1956 105,943 

1957 84,858 

1958 63,859 

1959 43,755 

1960 95,728 

784,499 

1961 40,731 

1962 24,013 

1963 11,394 

1964 (740) 

1965 (8,933) 

1966 121,301 

Total $972,265 



TABLE 2 

Estimated Gains after Taxes Realized by Victor 
from Purchase of Blackstone's 30% Interest 





Victor's Income 


Victor's Income 






From Shurcliffe 


From Shurcliffe 


Gains Resulting 




After Purchase 


Before Purchase 


From Purchase 




(100% Interest) 


(70% Interest) 




1953 


$ 400,275 


$ 221,002 


$ 179,274 


1954 


718,916 


378,802 


340,114 


1955 


627,247 


311,025 


316,222 


1956 


515,144 


247,200 


267,944 


1957 


438,706 


198,002 


240,704 


1958 


362,517 


149,007 


213,511 


1959 


287,170 


102,098 


185,072 


1960 


224,767 


223,365 


1,402 


1961 


166,564 


95,036 


71,529 


1962 


108,994 


56,033 


52,961 


1963 


67,506 


26,584 


40,922 


1964 


33,739 


(1,726) 


35,464 


1965 


4,159 


(20,844) 


25,002 


1966 


311,518 


283,034 


28,484 




$4,267,222 


$2,268,616 


$1,998,605 



BLACKSTONE MINING COMPANY 



265 



EXHIBIT 1 

Financial information on Victor Mines Inc., in Millions 





i,952 


1951 


1950 


1949 


Current Assets 


10.9 
40.0 
4.1 
32.6 
35.9 

33.0 
4.0 

8.44 
3.40 
85 


10.3 
37.3 
3.9 
30.2 
33.4 

30.2 
3.8 

7.90 
3.30 
73 


10.3 
35.0 
4.1 
28.0 
31.6 

31.1 
4.3 

8.76 
3.22 
663^ 


9.3 


Total Assets 


32.8 


Current Liabilities 


4.3 


Net Worth 


25.5 


Debt and Net Worth . . . 


28.5 


Sales 

Net Income, After Taxes 


31.1 
4.2 


Earned per Share 

Dividend per Share 

Price per Share ( average ) 


8.84 
3.19 
63 



EXHIBIT 2 

Financial Information on Blackstone Mining Company 





1952 


J95i 


J 950 


1949 


Total, in Millions of Dollars 

Current Assets 


91.9 
286.6 

33.9 
217.4 
253.0 
236.8 

25.3 

10.68 
5.35 
165 


88.4 
273.7 

34.7 
203.5 
239.1 
220.3 

22.6 

9.53 
4.85 
1283^ 


89.4 
256.3 

34.8 
191.3 
221.6 
215.1 

22.8 

9.55 
4.85 
120 


82.3 


Total Assets 


237.2 ■ 


Current Liabilities . 


29.8 


Net Worth . 

Debt and Net Worth 


177.9 
207.3 


Sales 

Net Income, After Taxes 


201.9 
20.9 


Per Share, in Dollars 

Earned per Share 

Dividend per Share 

Price per Share (average) 


9.18 
4.50 
112)^ 



ease 2S 

ACADIA AUTO ACCESSORIES, INCORPORATED 

Self-Insurance on Workmen's Compensation 

This case offers the opportunity to analyze figure data as an aid 
in reaching a decision as to whether or not to self-insure for work- 
man's compensation insurance. The issue offers the typical dilemma 
of lack of certainty in considering alternate courses of business 
action. 

Acadia Auto Accessories, Inc., manufactured light-rolled metal 
products for automobile and appliance manufacturers. The company 
was the major employer in a small Massachusetts town. Labor turn- 
over was low, and management considered employee relations to be 
excellent. There was no union. Sales were roughly five to seven 
million dollars annually. Exhibit 1 shows Acadia's financial condition 
at the end of 1948 and 1951. 

The company had grown from a shoestring operation in 1931 with 
11 employees to over 500 employees in 1951, half of whom were 
women. 

Accidents were few and rarely serious. Operations were not par- 
ticularly hazardous; most of them were done on continuous strips 
of material. Thus, although there were many punch press operations, 
few of them involved hand feeding. 

In 1952, Mr. Harry Parker, treasurer, and Mr. A. J. Devlin, con- 
troller, of Acadia Auto Accessories, Inc., were considering the ad- 
v^isability of self-insuring their workmen's compensation liability. 
Mr. Devlin had felt for some years that the company was paying too 
much for workmen's compensation insurance. Recently he had 
counted the number of days lost on account of industrial accidents 
during the past three years. He found that the average annual 
number was about 1,000. As premiums were about $30,000, this 
meant an average daily cost of $30 which he felt was excessive, es- 
pecially since he could remember very few cases involving expensive 
surgery or lengthy disability. 

Accordingly Mr. Devlin phoned Mr. T. K. Conklin of Hamilton, 

266 



ACADIA AUTO ACCESSORIES, INC. 



267 



Harrison and Conklin, general insurance brokers, who had handled 
Acadia's insurance for years, and asked him to call in to discuss ways 
of reducing compensation expense. Mr. Devlin added that he was 
thinking seriously of self-insurance. 



EXHIBIT 1 

Condensed Balance Sheet 



Assets 



Cash 

Accounts Receivable 

Inventories 

Securities 

Plant and Equipment, Net 

Prepaid Items 

C, S. V. Insurance 

Liabilities 

Accounts Payable 

Notes Payable 

Reserve for Contingencies . 

Capital Stock 

Surplus 



December 31 , 


December 31 , 


1948 


1951 


$ 185,134 


$ 446,264 


368,352 


371,831 


473,796 


760,963 


65,000 


— 


403,583 


775,340 


10,651 


11,395 


20,910 


20,954 


$1,527,426 


$2,386,747 


$ 385,386 


$ 505,703 


60,000 


80,000 


62,500 


200,000 


420,000 


420,000 


599,540 


1,181,044 


$1,527,426 


$2,386,747 



When Mr. Conklin called, a few days later, he agreed that the in- 
surance company was probably making money on Acadia business. 
"Your losses are below the industry average," he said. "Acadia is an 
unusually safe place to work. There are no toxic or explosive ma- 
terials or even anything unusually inflammable anywhere in the 
plant. But all that is figured in your rate and if your losses stay low 
your rate will come down. Anyway you could not possibly assume 
all your own workmen's compensation liability. It would be too 
risky." Mr. Conklin pointed out that most of Acadia's buildings were 
more than 100 years old, and since they were perched on the edge 
of a river a building might possibly collapse, injuring 100 people 
or more all at once. 

"Fortunately," Mr. Conklin continued, "a half-way course is pos- 
sible. Our company offers a self-insurance plan whereby for thirty 
per cent of the normal premium you get loss prevention, claim 



268 THE ROLE OF FINANCIAL ANALYSIS 

settlement, and rehabilitation service plus a reinsurance policy that 
would take over all losses beyond your normal premium. Here is the 
proposition." He then presented the memorandum shown as Ex- 
hibit 2. 

After Mr. Devlin and the treasurer had looked over the plan, Mr. 
Parker remarked, "Let me see if I have this right. We pay thirty 
per cent of the premium to you. You look after all the administration, 
claim settlement, loss prevention, and all that. We pay all losses up 
to seventy per cent of the premium, which brings our total possible 
expenditure up to the same amount as we now pay to the insurance 
company. You pay everything over that." 

Mr. Conklin answered, "That is correct, except that we are not 
underwriters ourselves— we reinsure with other companies." 

Then Mr. Devlin said, "We also have to pay $300 per year for the 
bond and $330 for the $1 million of extra coverage. Who writes the 
checks to the injured employees? If we do, that would cost something 
unless we could find someone not too busy to have that added to his 
duties." 

Mr. Conklin replied, "Yes, that would add something for clerical 
costs. Most companies prefer to write the checks. The fellows will 
know you are self-insured that way. Anyway, we are not allowed to 
negotiate with the injured employee. The lawyer who does all the 
claim settlement work acts as your representative, not ours. You 
give him all the details of the man's pay, and so on. He figures out 
the settlement and you write the check." 



EXHIBIT 2 

Memorandum 

TO: Acadia Auto Accessories, Inc. 

FROM: Hamilton, Harrison and Conklin 

RE: Workmen's Compensation Self-Insurance Plan 

Based on an estimated premium of $29,000 for the coming year, we are 
prepared to furnish an aggregate excess reinsurance contract at a cost of 30 
per cent of this estimated normal premium which guarantees that all losses 
in excess of 70 per cent of the normal premium would be paid by the reinsurers. 

The aggregate excess reinsurance contract furnishes complete claims and 
safety engineering services such as are now provided by the company writing 
their full-cover Workmen's Compensation insurance. 



ACADIA AUTO ACCESSORIES, INC. 269 

The 70 per cent balance of the estimated annual normal premium remains 
in the assured's possession, and as losses occur they are paid out of this fund 
after complete investigation and adjustment by the claims department of the 
reinsurers. 

At the end of the insurance year, any balance remaining in this 70 per cent 
fund, after the payment of losses and provision for outstanding reserves, repre- 
sents a cash-in-hand saving to the assured. 

If, on the other hand, the losses should exceed 70 per cent of the normal 
premium, then the reinsurance company would pay all in excess thereof. 

Thus, the assured is placed in the position where his maximum potential cost 
cannot exceed the premium he would otherwise pay for full-cover insurance 
and if, on the other hand, the losses are less than 70 per cent of the developed 
normal premium, he would have realized a saving in this otherwise dead weight 
operating expense. 

The state requirements for a self-insurer under the Workmen's Compensation 
Law make it necessary for the assured to apply to the Industrial Accident Board 
on a form which is enclosed herewith for a license to self-insure under the 
Compensation Law. 

After approval by the Board, they will require that the assured furnish the 
state with a self -insurer's bond in an amount which is at the discretion of the 
Industrial Accident Board, but we should estimate that in this instance the 
bond should be in the vicinity of $30,000 or $40,000. 

The cost of the self -insurer's bond is $7.50 per $1,000 and this cost is in 
addition to the cost of the reinsurance. 

We failed to mention above that the aggregate excess reinsurance contract 
would contain a limit of $200,000 and for additional coverage a supplementary 
aggregate excess contract in the sum of $500,000 may be purchased at an 
additional cost of 1 per cent of the assured's normal premium or, in this 
instance, $220, or $1,000,000 supplementary coverage may be purchased at a 
cost of 1/2 per cent, or $330 in this example. 

Mr. Devlin then asked how a case involving long-term disability 
would be handled. He explained that in 1951 a new employee, named 
Elmore, had slipped while carrying a load, and had suflFered a hernia 
that, according to medical opinion, might render him permanently 
unfit for physical labor. Acadia's insurance company was required to 
take care of him indefinitely or until he was rehabilitated. Mr. Devlin 
wanted to know whether under self-insurance, the cost for future 
years would be charged against the year the expenditures were 
made or against the year the man was hurt. 

"Yes," said Mr. Conklin, "against the year he was hurt. We make 
a guess as to the probable future cost of caring for him until rehabili- 
tated and that is counted as a loss for the year in which the man is 
injured. If you had had this plan last year you would have paid 
Elmore's medical expenses and weekly compensation and, as ap- 
proved by us, you would have set up as a reserve the amount we 



270 THE ROLE OF FINANCIAL ANALYSIS 

suggested to take care of him in the future. You would start over 
with a clean sheet the next year." 

After Mr. Conklin had gone, Mr. Parker and Mr. Devlin discussed 
his proposition further. They felt that an outside safety engineering 
service was not as important to Acadia as it used to be. Every ma- 
chine in the plant was now equipped with the most modern safety 
devices. Many had been designed by Acadia engineers with an eye 
to safety, and the inspector from the insurance company had found 
no fault with the safety precautions built into the machines. The 
state inspector had found no fault with the plant at any time. In 
general, they thought that the Acadia engineers were sufficiently 
aware of the safety devices in general use to have no further need 
of an outside assistance. 

During the next week Acadia was visited by a safety engineer 
from Hamilton, Harrison, and Conklin and by a claim settlement 
expert who was a member of a legal firm which did much of this 
sort of work for Hamilton, Harrison, and Conklin. 

Mr. Devlin accompanied the safety engineer on an inspection tour 
of the plant. Judging by his experience with previous safety engi- 
neers Mr. Devlin thought this man more thorough than the state 
inspectors had ever been and quite as thorough as the inspectors 
from Acadia's present insurance carrier. At the end of his tour the 
inspector remarked that everything looked very good to him and 
was a credit to the company engineers and the previous insurance 
inspectors. Next, he produced some figures for other companies 
which showed a considerable decline in workmen's compensation 
expense since the introduction of plans similar to that proposed for 
Acadia. He also produced a long list of names of companies in Mas- 
sachusetts which had adopted the plan. "We have looked after these 
people for years now," he said. "Ask any of them how we stack up." 

The lawyer also had a look around the plant but spent most of his 
time discussing workmen's compensation cases in which he had par- 
ticipated. He was pleased to learn that a medical examination had 
been made a standard part of the induction process early in 1952. 
"This, " he said, "helps cut losses, keeps unfit men out of dangerous 
jobs and helps fix responsibility in the event of loss." 

The following day Mr. Devlin called on the commissioner of self- 
insurance for workmen's compensation in Boston, and explained 
the step his company was considering. He asked him how the board 



ACADIA AUTO ACCESSORIES, INC. 271 

felt about self-insurance on workmen's compensation and if compa- 
nies similar to Acadia had had a satisfactory experience with it. The 
commissioner, assured him that the procedure was perfectly legal 
and so long as the rules were complied with there was no danger of 
opposition from the board. The commissioner went on to say, "The 
service companies have been doing a good job. They have made self- 
insurance possible for many companies which would be quite unable 
to obtain the necessary reinsurance or perform the necessary service 
functions themselves." 

Mr. Devlin also asked the commissioner if Acadia were large 
enough to self-insure. He replied that there were many smaller com- 
panies doing it and that any company could, technically, qualify by 
providing a bond of $20,000, but as a practical matter a company 
could only undertake such a program if it could obtain reinsurance 
to protect it against calamity losses. Companies which developed a 
premium of less than $15,000 typically were unable to obtain rein- 
surance. "Your premium," he added, "is nearly twice that big." 

Mr. Devlin's next question was, "Do many people go back to 
insurance companies after trying self-insurance?" 

To this, the commissioner answered that by March 31, 1952, about 
230 Massachusetts companies had applied for a license to self-insure. 
Of these 51 had gone back to insurance companies— mostly because 
they were too small. They just didn't develop enough premium to 
make it worth while for a company like Hamilton, Harrison, and 
Conklin to handle the services and arrange the reinsurance or "stop 
loss insurance," as it is sometimes called. "Of course," he added, "the 
program is very young in Massachusetts. We have only been run- 
ning it since 1943. It takes 5 or 6 years to evaluate such a program 
properly. 

"As to whether you could save money by self-insuring I cannot 
say. Results are hard to measure. Self-insurers do not often segregate 
all their insurance costs. They also seem to pay out more per claim— 
or at least a Pennsylvania survey ^ conducted in 1934 showed that 
self-insurers paid out twice as much per claim as did insured com- 
panies. This might be generosity, ignorance, or carelessness and in any 

1 "Self-insurance of Workmen's Compensation in Pennsylvania," by Howard M. 
Teaf, Jr., Pennsylvania Department of Labor and Industry, Special Bulletin, No. 40, 
Part II. 



272 THE ROLE OF FINANCIAL ANALYSIS 

case is claimed to have a good effect on employee relations which 
offsets the higher cost by better productivity. The figures may not 
mean much, however, since self-insurers do not always report minor 
compensable injuries which would have helped the average. 

"Insurance companies' expenses break down something like this: 

Sales Costs— Commissions, Expenses, etc. 10% 

Claim Adjustments 10 

Rating Bureau and Inspection Expenses 4 

License Fee and Taxes 2 

Home Office Expense 10 

36% 

The rest of the premium income goes to pay losses. Some of those 
functions can be eliminated by self-insuring— some you might be 
able to do cheaper." 

Mr. Devlin then called on one of the larger insurance companies 
in town and explained to their workmen's compensation expert, Mr. 
Morrow, that he was considering self -insurance and wondered 
whether he could get the other side of the story. Mr. Morrow leaned 
back in his chair and said, "To begin with, we are not against self- 
insurance. As far as we are concerned it is just another competitor 
like X Company or Y Company down the street. We believe there is 
a place for self-insurance and yet we try and get all the business we 
can. Why doesn't everybody do it? Well, I'll tell you. 

"People who self -insure can be divided roughly into five groups. 
First of all, there are the large nonprofit organizations like Harvard 
University. They have any amount of money to put up as a guarantee 
of their ability to pay. Since they continue to collect interest and 
dividends it costs them nothing to tie up capital in this way. Maybe 
they pay more as self-insurers than they would if they were insured 
with a company, but they would rather have it that way. They feel 
they get it back in terms of good will. 

"Then there are the huge national concerns like Dupont, Ford, 
and Sears. They have as much diversity of activity and geographical 
dispersion of risk as many insurance companies. 

"The third group comprises the large local concerns such as New 
England Telephone and Telegraph, the Boston and Maine Railroad, 
and some other railroads. These people obviously have all the char- 



ACADIA AUTO ACCESSORIES, INC. 273 

acteristics of self-insurers, and they have traditionally adhered to a 
policy of self-insurance or noninsurance. 

"There are always a few cranks who don't insure because they 
don't like insurance companies or because they have had a bad ex- 
perience. They may think they're self-insuring, and sometimes they 
are; but sometimes they're just taking risks. They don't have any 
diversification. They don't have a big enough operation to warrant 
providing service facilities. Their premium would be trivial com- 
pared to the risks they run. 

"The fifth group is the group into which you fall. You're not big 
enough to provide all these services yourself, but you can buy them 
through a service company. You are not financially strong enough 
to stand catastrophe losses, but you can buy reinsurance. You are 
certainly big enough to qualify for reinsurance and develop a big 
enough premium to make it worth while for a service company to 
take over the account. The tough question to answer is whether or 
not you should self -insure. You must remember that workmen's 
compensation costs are rising. Hospital expenses for a hernia case 
used to run about $6 a day in 1942. They now run from $12 to $24. 
The operation itself cost $350 in 1942; it now costs $750. Weekly 
compensation is going up, too, to meet the rising costs of living. And, 
as you know, it is the policy of the government for social benefits of 
this sort to be enlarged rather than diminished. New types of dis- 
ability are being included all the time. All this works in favor of 
buying insurance, since all premiums are based on past experience 
one way or another, and future costs these days have been higher 
than past costs. On the other hand, the frequency and severity of 
industrial accidents is being reduced all the time by the fine loss 
prevention work we do. Of course, the state provides an inspection 
service too, but you have had enough experience already to know 
that the insurance company inspector is much more thorough than 
the state one. 

"The biggest and best argument," concluded Mr. Morrow, "is that 
hundreds of companies, large and small, many of which could easily 
qualify for self -insurance and meet all the traditional tests as to size, 
dispersion, diversity of occupations, and so on, still prefer to buy 
insurance. They would rather have their injured employees deal with 
an insurance company. This turns antagonisms away from the com- 
pany. I could name a very large company, one of the biggest. They 



274 THE ROLE OF FINANCIAL ANALYSIS 

were self-insured, and had an insurance department as big as some 
insurance companies. Then they made the insurance department 
into a separate insurance company. They didn't Uke the way the in- 
surance department employees got so friendly with the others. They 
said the employees didn't like fighting for a better settlement against 
their own company. Now the insurance company takes all the 
knocks. The men don't blame the company, and when company 
officials help a man get a decent break they get credit for it. That 
company is big enough to have it both ways. I could give you a list 
of companies that do insure, hundreds of times longer than the list 
of those that self-insure, and it would include some of the best com- 
panies in the country. Here is a little note we give to our agents to 
help them hang on to a client who is considering self-insurance. I 
think you should look it over." ( See Exhibit 3. ) 

Mr. Devlin next visited the Massachusetts Workmen's Compensa- 
tion Rating and Inspection Bureau where he asked for an explana- 
tion of the rating system so that he could understand why Acadia's 
premiums were so high compared to losses. This is what he was told: 

"We set all rates for workmen's compensation in this state. Losses, 
premiums, payrolls, and other useful statistics concerning the ex- 
perience of all insured companies in the state are reported to us. In 
order to simplify the rate-setting process and to produce large 
groupings for the application of probability analysis, all companies 
are classified into industry groups according to frequency and sever- 
ity of accidents. Acadia is classified as a light hardware manufacturer 
designated number 3146. This classification includes some compa- 
nies whose operations are more hazardous than yours and perhaps 
some that are less hazardous but they are all nearly alike. The man- 
ual rate for classification 3146 depends on the losses of all the com- 
panies in the group, not just Acadia. 

"The manual rate is then adjusted to make allowances for the 
experience of the individual companies. The adjustment is either 
debit or credit. Because there are so few manufacturers in your 
classification and because you are a relatively small company, ad- 
justment that gave full credibility to recent industry experience or 
to your own recent experience would result in a wildly fluctuating 
premium and no one would be happy. So recent years do not have 
a heavy weighting. It takes a long time under those circumstances 



ACADIA AUTO ACCESSORIES, INC. 275 

for the experience modification to result in a premium you would 
consider fair and reasonable when losses are falling. But it works to 
your advantage when losses are rising." 

While he was at the rating bureau Mr. Devlin obtained the data 
shown in Exhibit 4 concerning the experience of Acadia over the 
last 8 years. 

Mr. Devlin returned home and found a letter (Exhibit 5) from 
Mr. W. J. Rhodes, the office manager of a manufacturing company, lo- 
cated in Exdale, an industrial city in western Massachusetts. Mr. 
Devlin had heard that Rhodes' company had recently dropped self- 
insurance of workmen's compensation and had written for particu- 
lars. 



EXHIBIT 3 

Factors to Consider Before Undertaking 
Workmen's Compensation Self-Insurance 

The advantages of self -insurance are based on two major premises: 

1. A savings in insurance costs; and 

2. An improvement in employer-employee relationships. 

If both of these situations obtain, naturally, there is an advantage of self- 
insurance. However, there is no certainty that they will. The disadvantages, on 
the other hand, are many: 

1. Before going into this plan, consideration must be given to the matter of 
discontinuing it, if need be, and the attendant difficulties. The necessity 
or desire to change back would occur under two important circumstances. 

a. The increased cost of reinsurance or the loss of your reinsurance 
market (which is foreign and therefore susceptible to either 
condition ) ; or 

b. Bad experience (which would make it entirely impractical for you 
to continue the plan). 

You would have two immediate, and probably expensive, problems in 

withdrawing from the self-insurance plan. 

First, you would have to agree with the reinsurer on reserve amounts 

sufficient to carry outstanding cases to their conclusion, or you would 

have to make lump sum settlements. In effecting a lump sum settlement, 

you are apt to be faced with this situation: 

Although the employee, in his own interest, and you, in his and your 

interests, will want to make settlement as substantial as possible, your 

reinsurer will want it to be made on the smallest possible basis. This 

diflFerence of attitude could very well lead to a dispute. Disputes of this 

nature have been settled by recourse to the courts. 



276 THE ROLE OF FINANCIAL ANALYSIS 

Second, in order to return to standard Workmen's Compensation, you 
\ would be required to file a bond with the insurance department. To 
satisfy the department, you would be required to file a bond in an 
amount sufficient to settle all of your outstanding cases. 
■ ' As you know, your liability would be absolute and might, therefore, 
involve a long-term commitment. Bonding companies do not normally, 
regardless of the soundness of the business concerned, write long-term 
bonds without full cash collateral. Thus, you might be put in a position 
of having to produce cash collateral of thousands of dollars to cover the 
full equity of outstanding cases, in order to secure the necessary bond. 

2. The normal plan for self -insurance calls for a maximum catastrophe limit 
of $250,000. Under the Workmen's Compensation Law, the employer has 
complete and unlimited liability. 

As an example of how extremely dangerous it is to limit your liability 
(which the self -insurance plan does), we cite the case of Monsanto 
Chemical in Texas City. The private carrier had reinsurance of several 
million dollars, which turned out to be inadequate. However, the loss 
differential had to be absorbed by the carrier and not by Monsanto. 
Under a self -insurance plan, in the event of a catastrophe loss, the excess 
over $250,000 would be borne by the employer. 

3. Another undesirable feature of self -insurance is the reimbursement 
operation. Under the reinsurance arrangements, the self -insurer has to 
distribute checks for all payments due to injured employees, and he will 
be reimbursed for such payments by the reinsurer within a two-year 
period. Aside from the fact that the reinsurer has the use of your monev 
for two years, such an arrangement necessarily entails the setting up of 
a bookkeeping system. 

4. Taxwise, the disadvantage of self-insuring is that, in the event of an 
accident, although a full reserve for possible claim must be set up 
immediately, tax credit is allowed only on amounts paid out. No tax 
allowance is permitted until moneys have been actually disbursed to 
the employee or employees. 

5. Under a regular workmen's compensation insurance policy, the company 
. carrying your coverage is desirous of keeping the cost as low as possible 

and the experience as good as possible, as its method of making a profit. 
Under a self-insurance plan, the service representative receives a per- 
centage of the standard premium developed by the risk. The only way 
in which the service company's financial benefit can improve is by 
increases in the standard premium. This position, obviously, is exactly 
opposite to that of the regular insurance carrier. 

Under these circumstances, it is easy to understand why the regular 
insurance company's engineering facilities should be fai- superior (since 
they stand to benefit thereby) to the engineering facilities provided by a 
service representative (whose sole financial gain would result from worse 
rather than better experience). 

We think that the above possible disadvantages should be given serious study 
before any action is taken. 



ACADIA AUTO ACCESSORIES, INC. 



277 



EXHIBIT 4 

Workmen's Compensation Experience, 1944-1951 





Payroll 


Premiums 


Losses * 


1944 


N.A. 


$ 4,184 


$ 1,110 


1945 


$ 325,000 


4,717 


1,441 


1946 


517,000 


8,504 


5,557 


1947 


692,000 


10,949 


5,646 


1948 


825,000 


17,689 


16,262 


1949 


942,000 


20,518 


6,313 


1950 


1,244,000 


32,996 


11,158 


1951 


1,284,000 


29,520 


20,772 



* Losses include treatment and compensation payments for cases originating in the current insurance 
year and also a reserve for payments for employers whose disability is expected to last longer than the 
current year. 



EXHIBIT 5 

Dear Mr. Devlin: 

You asked me if we had the same self-insurance plan as you are considering 
and also why we dropped it. From your letter, I gather that the service com- 
pany arrangement with stop-loss reinsurance is identical to our own. We 
dropped it because our losses went up and it proved to be too costly. We found 
ourselves paying for service and doing it ourselves at the same time. Then we 
had a change of management and the new management didn't like self- 
insurance; so we have gone back to an insurance company. 

The bad losses seemed to be just tough luck. One of our female employees 
developed a bad back and moved out of state. It was all very complicated and 
cost a great deal before we got it straightened out. Then we had a couple of 
serious burns from molten metals and a couple of hand amputations. Our 
losses far exceeded our old premiums. 

The second thing was the service. The safety man from the service company 
got around here once or twice a month. In a city the size of ours, all the big 
insurance companies are well represented by branch offices or agencies and 
since our industry is concentrated in this area, they are experts in our hne. Now 
the safety man is here two or three times a week and works closely with our 
new safety department. The same thing goes for claim settlements. When we 
were self-insured, the service company sent out a lawyer when we had an 
accident. Very often he couldn't get out here until the next day and sometimes 
longer. Now the insurance company representative is on the spot ten minutes 
after an accident. We can get him when we want him. Of course, your town 
is too small to support large insurance agencies or branch offices and I expect 
you get all of your service from Boston either way. 

The third thing was the cost of administration which proved much higher 
than we thought it would. There was check-signing and accounting for losses 
and reserves. We had to design special forms and special checks. We had an 



278 THE ROLE OF FINANCIAL ANALYSIS 

extra bank balance to reconcile each month, etc. We ended up with an 
insurance department of our own with seven full-time people in it. As to the 
psychological effect you inquired about, so far as I could see there wasn't any. 
One thing we do notice is that our losses have improved since we started 
buying insurance again but we also started our own safety department at that 
time. The safety fellows wander through the plant checking up on safety 
regulations, watching for hazardous situations, and working with the foremen 
to eliminate them. We consider the safety department a great success. 

This does not mean that I am advising you against self -insurance. It seems 
to work out fine with many companies, but it didn't work with us. Both of our 
local competitors took on self-insurance at about the same time we did. One 
still has it and claims that they are saving money. The other dropped it a year 
or two after they began. Incidentally, the company that dropped it had twice 
as many employees as we, that is, about 1,400. The one that is still self- 
insured is considerably smaller than we are so it is hard to generalize about size. 

Best regards. I will be interested to hear what you decide to do. 

Very truly yours, 

! W. J. Rhodes 

OfBce Manager 

Mr. Parker, Mr. Devlin, and the president planned to meet the 
following afternoon to discuss the proposition. An early decision was 
important, because the renewal date on the present policy was ap- 
proaching fast, and Devlin wanted to avoid the penalty involved in 
cancelling the policy part-way through the year. Parker was inclined 
from the first to accept the self-insurance proposal. The president, 
however, was against it at first, mainly on the grounds that it looked 
like "something for nothing" and had insisted on a very thorough 
survey of the problem before taking action. At the same time, he was 
not pleased with the way Workmen's Compensation costs were rising 
and was willing to explore this possible means of reducing them. 

How would you go about making this decision on self-insurance? 
What action would you recommend? 



case 



29 



THE NEW ENGLAND BAKING COMPANY 

Review of Insurance Carrier 

This case deals with a company's efforts to reduce insurance costs 
through a change in insurance carrier. It focuses on the analysis re- 
quired to reach a rational decision on the proposal under review. 

In November, 1954, Mr. Gordon Thompson, office manager of 
The New England Baking Company, Inc., was reviewing a report 
made by a local agent of the Gibraltar Insurance Company. (See 
Appendix 1.) According to this report. The New England Baking 
Company could have saved about $250,000 in 1953, with the same 
coverage, and even more in the future, by insuring with Gibraltar 
rather than with their present carrier. These savings were to be 
achieved partly by reducing hidden costs or uninsurable cost in op- 
eration (see Exhibits 1 and 2) and partly by lowering premiums. In 
the light of these impressive savings, Mr. Thompson was considering 
the advisability of transferring his company's business to the stock ^ 
company from the Pilgrim Mutual Insurance Company. 

Background History of Company 

In the last decade, the sale of The New England Baking Com- 
pany's products had more than tripled. Increased demand had 
necessitated the expansion of existing capacity largely through the 
addition of several new bakeries and sales agencies. Over the same 
period, the number of employees increased from 1,962 to 3,012. The 
president felt that the good profit record, sustained in the face of a 
severe postwar decline in U. S. bread consumption, testified to the 



1 The distinguishing feature of stock companies is that they are owned and con- 
trolled by stockholders and are operated to yield a profit to the owners. Liability is 
assumed by the company in its corporate capacity; a definite premium is charged and 
the consequences must be borne by the company alone, should losses exceed the 
premium income. 

Mutual companies also assume liability in their corporate capacity. Their distinguish- 
ing feature, however, is that they are controlled by the policyholders, instead of by 
stockholders, and any profits from operations accrue to the policyholders. 

279 



280 THE ROLE OF FINANCIAL ANALYSIS 

soundness of the company's policy of plant expansion and concen- 
tration on service to customers. 

The New England Baking Company had eleven baking plants lo- 
cated in strategic centers from the heart of New England to central 
Ohio. From each plant a large fleet of trucks distributed fresh bread, 
cakes, pies, and other products to surrounding communities. In ad- 
dition, these plants delivered fresh bakery products daily to thirteen 
sales agencies, all of which, in turn, operated fleets of trucks for dis- 
tribution to more distant communities. 

Present Insurance Program 

For the last fifteen years or more. Pilgrim Mutual Insurance Com- 
pany had handled New England Baking Company's workmen's com- 
pensation, auto liability, and products liability insurance. In discus- 
sing the Pilgrim plan, Mr. Thompson said, "We like to feel that we 
are self-insured and in a way we are. We pay a premium that is de- 
termined in advance each year in accordance with a rating plan 
which reflects our past experience. For workmen's compensation, for 
example, the ratio of losses to payroll is averaged over the past three 
years. This loss ratio is then applied to our projected payroll for the 
coming year. The insurance company then applies a factor which 
provides for their loss prevention and claim settlement costs and 
allows them something towards their reserve for extraordinary losses 
and general overhead and profit. In calculating the loss experience, 
no claim is counted for more than $10,000, even if an award greatly 
in excess of this amount is paid by the insurance company. This is, 
we feel, something like being self-insured. In the end we pay for the 
cost of every accident up to $10,000 per claim. The fact that we pay 
a premium to the insurance company instead of paying doctor bills 
and hospital charges does not blind us to our own responsibility to 
keep losses at a minimum. On the other hand, the averaging process 
has the effect of spreading any unusually serious loss in one year 
over a three-year period. That is, if we had a bad explosion in one 
year, it would be reflected in our insurance premium in each of the 
three years beginning with the second year following the catastrophe. 
So, even though our premiums are closely tied to our losses, we still 
have fairly uniform insurance costs. " 

Mr. Thompson was not dissatisfied with the loss record and with 
the service rendered by the Pilgrim Mutual. Pilgrim representatives 



THE NEW ENGLAND BAKING COMPANY 



281 



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282 



THE ROLE OF FINANCIAL ANALYSIS 



had repeatedly come in and organized safety programs in coopera- 
tion with the New England management. On several occasions they 
had sent specialists to analyze processes and materials when it was 
suspected that some toxic material or gas was responsible for recur- 
ring illnesses on certain jobs. The Pilgrim men had always continued 
the special investigations until the trouble was found and corrected. 
The Pilgrim representatives had always seemed to Mr. Thompson to 
be efficient, willing to be helpful, and easy to get along with. Reports 
from the managements of the numerous other factories and distribu- 
tion centers included in the program confirmed Mr. Thompson's 
opinion that the Pilgrim men would be hard to beat when it came to 
courtesy, efficiency and service. 

EXHIBIT 2 



BUSSES, TRUCKS 
OR OTHER CARS 



Reduced EARNrNcs 

ON CAPITAL INVESTED 
IN VEHICLES 



SUMMARY OF COST 
FACTORS OF AUTONOBILE 
•FLEET ACCIDENTS ' 



DRIVERS 
AND HELPERS 



Waoespaidto drivers 
or helpers made idle 
because of accidents 



LOSS OF TIME 



BYMANACEMtNTINVEST- 
lOATING ACCIDENTS AND 
PREPARING REPORTS 



ADDITIONAL 
OVERHEAD 



Labor CHARGES OR EX- 
PENSE OF HANDLING 
MERCHANDISE DAMAGED 
BECAUSE OF ACCIDENTS 



CONTINGENT 



Loss OF GOOD WILL OF 
PUBLIC OR CUSTOMERS 
AS RESULT OF COHPANV 
VEHICLES BEING IN- 
VOLVED IN ACCIDENTS 



Abnormal deprecia- 
tion OF VEHICLES 
DUE TO ACCIDENTS 



Reduced earnings 

ON INVESTMENT IN 
DRIVERS OR HELPER5 



6v DRIVERS ANO HELPERS 
MAKING STATE. REPORTS, 
DISCUSSING ACCIDENTS 
WITH INVESTIGATORS OR 
APPEARING IN COURTS 



Special deliveries 
and reroutingof 
goods because of 

DELAY BY AaiOENTS 



Reduced VOLUME of 

BUSINESS AS RESULT OF 
DISSATISFACTION CAUS- 
ED BY DELAYED ORDERS 



Excessive w€ar 
caused by reckless 

DRIVING RESULTING 
in ACCIDENTS 



Selecting.hiringano 
training new drivers 
and helpers replacing 
those having accident} 



By DRIVERS AND HELPERS 
RECEIVING FIRST AID, 
MEDICAL OR HOSPITAL 
ATTENTION 



Expense FOR SERVKE 

CAR,TOOLS OR OTHER 
EQUIPMENT AT SCENE 
OF ACCIDENTS 



INTERFERENCE WITH 
SCHEDULE WHICH CAUSES 
PATRONS TO SHIP OR 
TRAVEL BVOrwERRETHOOS 



Hiring SUBSTITUTES 

OR USING SPARE VE- 
HICLES DURING REPAIR 
OF DAMAGED VEHICLES 



Inefficiency OF 

DRIVERS OR HELPERS 
DISTRACTED OR MADE 
NERVOUS BV AaiOENTS 



By Company GARAGE 

MEN GIVING ASSISTANCE 
AT SCENE OF ACCIDENTS 



All of jLhe above factors produce costs in addition to payments 

for PERSONAL INJURY, 
for DAMAGE TO OTHERS' PROPERTY, 
for DAMAGE TO GOODS IN TRANSIT, 
and for DAMAGE TO THE VEHICLE ITSELF 
whether ornot these are covered by insurance 



In the matter of loss settlement, too, Mr. Thompson had found 
Pilgrim reasonable and fair. "They never go over our heads," he said. 
"They talk doubtful claims over with us, and they settle out of court 
if they think it is to our advantage to do so, and they fight when 



J 



I 



THE NEW ENGLAND BAKING COMPANY 283 

they should— that is, when they think a claim is exaggerated or false." 
Mr. Thompson thought that his company was being well looked after 
in insurance matters and at a reasonable cost. The fact that the 
present carrier was a mutual company had never seemed a matter for 
concern, although representatives of stock insurance companies had 
often expressed the opinion that the lack of an agent and the danger 
of assessments if losses were heavy were serious drawbacks. Mr. 
Thompson knew that some mutual companies charge a very low 
premium and assessed members if losses exceed expectations. Others 
charge a very high premium and rebate a portion at the end of the 
year as a "dividend" if the loss experience was normal. Still others 
charge about the same premium as the stock companies but assess 
their policyholders for any deficit and refund any surplus once an 
adequate reserve is built up. Some mutual companies made no assess- 
ments, being similar to the stock company in that regard. Pilgrim 
Mutual had paid a dividend for so long that Mr. Thompson always 
thought in terms of net premium or premium less "dividend." He 
did not recall whether Pilgrim could assess its policyholders in the 
event of unusual losses but thought not.^ 

Accordingly, when the broker representing the Gibraltar Company 
pointed out that in fifteen years there was grave danger of com- 
placency and high cost through lack of competition, Mr. Thompson 
was inclined to be skeptical. At the same time, he was a little dis- 
turbed at the way premiums were rising. As the rapid expansion of 
the last decade took place, the economies of larger scale production 
had materialized in many aspects of the company's business, but not, 
according to the agent, in insurance costs. Accordingly, partly in the 
hope that something might be discovered that would reduce ex- 
penses and diminish accidents, and partly on general principles, Mr. 
Thompson permitted the Gibraltar representative to proceed with 
the survey. Now having read it over, he thought that the size of the 
saving indicated, when compared with the company's net profit of 
about $500,000 in 1947 and $800,000 in 1948, was sufficient to war- 
rant careful consideration of the Gibraltar proposal. 

As Mr. Thompson, would you recommend transferring the company's 
insurance to the Gibraltar Insurance Company? 



2 In fact it could not and there were very few assessing companies in existence at 
that time. 



284 THE ROLE OF FINANCIAL ANALYSIS 

APPENDIX 1 

A Workmen's Compensation and Liability Insurance Proposal 

Introduction 

It is our objective in this proposal to establish that: 

I. As dollar sales, unit volume, payrolls, mileage, and other exposures 
increase, insured loss totals need not increase because losses can be 
controlled, and that 

II. Under insurance rating plans available to your organization you can 
obtain a realistic and direct reflection of the good results obtained by loss 
control, and that 

III. The joint effort made to control and reduce losses, and to reflect such 
control in reduced premium charges where possible, will result in a true 
low net cost on a continuing basis. 

Analysis of Current Program ^ 

From a study of data made available to us we have drawn these conclusions: 

1. You have sought and attained an apparent low net insurance cost. 

2. The trend of your experience over the useful past has shown no marked 
deviation from the periodic variations in the average. 

3. There has not been a proportionate climb of losses as your exposures 
increased; there has, however, been a marked rise. 

4. The prospective * rating technique has tied your current cost level to 
past performance and has not given sufficient incentive to improve loss 
results. 

5. Full weight has not been given to your own experience. On the 
contrary some weight has been given to the experience of other baking 
companies, which from manual rate indications has not been as good as 
yours. 

6. Recognition has not been given to the important elements of hidden, 
uninsurable losses, these charges to overhead which are the direct result 
of accidents (whether or not an insured loss follows) and which in total 
are a factor of greater dollar weight than insurance costs— and just as 
certain. 

Initial Approach 

In considering an improvement in your insurance arrangements on the types 
of coverage treated here we have in mind the development of low cost without 
sacrifice in coverage or in service. It is our aim to better both these last. 

Direct treatment of the cost problem prompts consideration of two basic 
points: 

1. The Question of Credibility 

2. The Question of Real Cost 

* Premium is based on an estimate of losses for next year (hence "prospective") 
as determined by average performance in the past. 



THE NEW ENGLAND BAKING COMPANY 285 

The Question of Credibility 

Our examination of your current rating program discloses at least seventeen 
different experience modifications. This indicates merely that to obtain escape 
from "book" rates based on the experience of all risks in the same field, your 
risk has been broken down into many separate units for the application of 
experience rating plans, either mandatory or optional. 

Obviously the weight given to your own good experience in your current 
rating varies directly as the size of your exposure premium in each rating. 
The ideal result lies in the treatment of all lines of the subject insurance in all 
states as an entity. Under existing state rate regulations the ideal situation is 
not attainable. 

An approach to substantial correction is to be had in superimposing upon 
as many of the underlying rating plans as is permitted, a Cost Plus rating 
formula, subject to a specified maximum and minimum. As against a current 
rating element of no more than 25 per cent in a single plan, you would then 
have an additional 50 per cent of your risk premiums in combination, subject 
to a single similar premium development formula. Since the attainable deviation 
from rates based on broad averages increases as the exposure base increases, 
the advantage to be gained is apparent. 

[Mr. Thompson understood this to be essentially similar to the present 
plan with Pilgrim, with the addition of a maximum and minimum 
premium and with emphasis on the experience of the current year as a 
factor in determining the premium instead of on the average experience 
of the past three years.] 

More important, however, is the operating principle of such a formula— a 
definite effect of the experience in a given year on the premium to be charged 
for that year. 

The Question of Real Cost 

To be specific, we may best use figures from your actual performance. 

From Chart 1 and its supporting "Consolidated Development Table 1947- 
1954" we can draw these figures: 

1950 1953 

Item I Payroll $ 5,516,110 $ 9,333,083 

Item II Sales 14,860,077 25,249,446 

Item III Automotive Units 1,041 1,308 

Item IV Gross Premiums (before dividend) 161,793 213,148 

Item V Net Premiums (after dividend) 129,435 170,518 

Item VI Insured Losses 65,896 140,756 

These figures indicate an apparent saving between Gross and Net (Item 
IV-Item V) of $32,358 in 1950 and $42,630 in 1953. However, a study of the 
full cost of accidents in your operations makes it necessary to add to your 
Insured Losses (Item VI) the increased cost of operations chargeable to these 
losses and the accidents which produced them: 

Item VII Uninsurable Cost in Operations $263,584 $563,024 



I 



286 



THE ROLE OF FINANCIAL ANALYSIS 
CHART 1 



200.000 



180,000 



160,000 



140,000 



120,000 



100,000 



80.000 




1950 



-Showing development of 
premium under proposed 
plan using actuol losses 



1951 



1952 



^Losses 



1953 



THE NEW ENGLAND BAKING COMPANY 

Relation of Premiums and Losses 

to Sales and Payroll under Present 

Insurance Plon 



1954 (est) 



Consolidated Development Table 1947-1954 



Year 


Payroll 


Sales 


Automobile 
Units 


Net 
Premiums 


Losses 


1947 


4,119,132 


10,837,973 


1,040 


111,104 


65,025 


1948 


4,552,258 


12,525,958 


963 


102,924 


54,643 


1949 


4,882,501 


13,196,893 


997 


107,086 


104,240 


1950 


5,516,110 


14,860,077 


1,041 


129,435 


65,896 


1951 


6,900,152 


18,999,353 


1,143 


168,891 


91,121 


1952 


7,905,753 


21,527,434 


1,302 


196,330 


100,080 


1953 


9,333,083 


25,249,446 


1,308 est. 


170,518 


135,330 


1954 


9,575,040 est. 


25,123,000 est. 


1,430 est. 


185,000 est. 


65,896 * 



Assumed to return to 1950 level. 



1953 


Increase 


$170,518 
563.024 


$ 41,083 
299,440 



THE NEW ENGLAND BAKING COMPANY 287 

This Item (VII) produces figures that are impressive, to say the least. They 
are based on the accepted principle that accident cost to management in terms 
of plant interruption, production loss, damage to raw materials or finished 
products, equipment upkeep and repair, lost time, morale impairment, and 
other blocks to efficient operation will run to four times the amount of indemnity 
paid as an insurance loss. 

In this picture your actual cost may be calculated thus: 

1950 

Item V Net Premium $129,435 

Item VII Cost in Operations 263,584 

$393,019 $733,542 $340,523 

In this comparison it is evident that the increase in your hidden loss was 
more than seven times greater than your substantial increase in insurance 
outlay. 



Real Cost Control 

It is our point that losses need not increase as payrolls and sales increase. 
On this principle we submit this table: 

Item I 1953 Payroll $ 9,933,083 

Item II 1953 Sales 25,249,446 

Item III 1953 Automotive Units 1,308 

Item IV 1953 Gross Premiums 213,148 

Item VI 1950 Insured Losses 65,896 

Item VII 1950 Uninsurable Cost in Operations 263,584 

In this illustration you bear only: 

Item IV 1953 Gross Premiums 213,148 

Item VII 1950 Uninsurable Cost in Operation 263,584 

Total Real Cost $476,732 

Thus by re-establishing the 1950 loss level in the face of 1953 exposures 
there is indicated for the year 1953 a real saving of $256,810. 

In 1955 you are faced with possible insurance cost increases; they can best 
be offset by loss control and its obvious effect on Item VII. 



The Value of Cost Plus Rating 

The figures on the preceding page in no way reflect the impact of the 
retrospective * principle. Under such a plan, keyed to participation in the 
results of accident prevention, our Table of Real Cost would be thus improved, 
assuming a similar loss distribution: 

Present Plan Cost Plus Plan 

Item IV 1953 Premium $170,518 $154,126 

Item VII 1950 Uninsurable Cost in Operation 263,584 263,584 

$434,102 $417,710 

* Premium based on current year loss experience which can be known only at the 
end of the year ( in retrospect ) at which time the premium is adjusted. 



288 



THE ROLE OF FINANCIAL ANALYSIS 



Here we have indicated a further saving, through rating technique alone 
of $16,392. 

We submit that such a combined potential, totalhng $273,202 must stand 
as a real objective for management. It requires no guarantee; attainment of any 
major portion of the objective would be worth while. 



The Test of the Proposal 

Because our program involves a combination of fixed and flexible rating 
plans, a condensed presentation of the results it would have produced for you 
is best given in totals. On the basis of a careful study of the distribution of 
premiums and losses we find that your insurance premium would have been: 

$ 3,320 more in 1950 

22,404 less in 1951 

18,357 less in 1952 

- - 37,365 more in 1953 



See also Chart 2.) 



76 more over 4 years 



From this coincidence we draw no conclusions; it is more important to 
consider the beneficial effect of such a plan in full operation, backed by an 
accident prevention and claim engineering program keyed to your risk on the 
basis of a plant-by-plant study for the discovery and analysis of the loss 
producing causes. 



CHART 2 



Premkffns 

a 

Losses 



250.000 



200,000 



150,000 



100,000 



50,000 



- $ 



























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/ 




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a 

Soles 



25,000,000 



20,000,000 



15,000,000 



10,000,000 



5,000,000 



1947 



1948 



1953 



1954 (est) 



THE NEW ENGLAND BAKING COMPANY 

Premium Payments and Losses Under the Existing Plan 
ond Proposed Plon 



THE NEW ENGLAND BAKING COMPANY 289 

The Proposed Underwriting Plans 

Our proposal contemplates the use of three underwriting plans, as follows: 

1. A Retrospective Rating Plan known as "Plan D" 

2. A Retrospective Rating Plan known as the "Massachusetts Workmen's 
Compensation Retrospective Rating Plan" 

3. A Fixed Price Plan 



Retrospective Rating Plan D 

This plan will apply to "Workmen's Compensation and Employers Liability 
Insurance" in: 

Rhode Island Maine 

New Hampshire New York 

It will apply also to Comprehensive Liability Insurance (except in New 
Jersey) to the limits specified: 

Each Person $10,000 

Each Accident 10,000 

Aggregate 25,000 (where apphcable, that is, Products Liabihty 

and Property Damage, Operations Property 
Damage, Protective Property Damage, Contrac- 
tual Property Damage) 

Note A: Application to New York Compensation subject to $10,000 loss limit. 

Note B: Application to Massachusetts Automobile Bodily Injury limited to 
nonstatutory coverage and the excess over statutory to $10/10,000. 

The Retrospective Premium, bracketed by the minimum and maximum 
Retrospective Premiums, will be the sum of: 

1. The Basic Premium— a percentage of the standard premium, calculated 
by states and lines of insurance, as outlined above. 

2. The Incurred Losses multiplied by the Loss Conversion Factor, the 
resulting total (by states and by lines) to be multiplied by the appro- 
priate tax multiplier. 

The first computation of the Retrospective Premium will be made between 
July 1 and September 1, 1956. This computation will be based on Incurred 
Losses valued as of June 30, 1956. 

This Retrospective Premium may be the final premium for the year, if all 
Incurred Losses have been paid or if it is apparent that the Retrospective 
Premium will exceed the Maximum Premium. 

If this first computation is not final, another shall be made between June 30 
and September 1, 1957. This computation will be based on Incurred Losses 
valued as of June 30, 1957. 

Further computations, if necessaiy, will be made if approved by the rating 
organizations having jurisdiction. 



290 THE ROLE OF FINANCIAL ANALYSIS 

The Incurred Losses used in calculating the Retrospective Premium will be: 

1. For Workmen's Compensation and Employers Liability Insurance— the 
actual paid losses and the reserves as estimated by the Gibraltar Com- 
pany for unpaid losses. 

2. For Comprehensive Liability Insurance— the actual paid losses and the 
reserves as estimated by the Gibraltar Company for unpaid losses, subject 
to the limits for each person, each accident, and the applicable aggregate 
as outlined above, plus allocated loss expense. 

The factors (rating values) of our proposed Plan D are these: 

Percentages of Estimated Standard Premium 

Factor ' 50% 100% 150% 

Standard Premium 60,000 120,000 180,000 

Basic Premium (average) 22.6% 20.7% 20.1% 

Minimum Premium f 23.4% 21.6% 20.8% 

Maximum Premium 140.0% 139.5% 139.0% 

Loss Conversion Factor 1.13 1.13 1.13 

Tax Multiplier (average) 1.035 1.035 1.035 

Intermediate factors to be determined by linear interpolation. 

t Basic Premium X Tax Multiplier. 

note: The following Basic Premium percentages determine the average given above 
at the 100% level: 

New York Compensation 26.5% 

Other Compensation 17.5% 

, . , New York Liability 24.0% 

Other Liability 11.5% 

The Tax Multiplier is simply a ratio designed to reflect the difl^erent tax 
situations in different states. It saves the expense and trouble of devising rate 
schedules each time taxes change and of having a separate rate for each 
taxation jurisdiction. 

The following tax multipliers apply: 

Compensation 

New York 1.036 

Maine 1.026 

New Hampshire 1.026 

Rhode Island 1.047 

Massachusetts — 

Ohio - 

Pennsylvania — 



General Liability 


Auto Liability 


1.031 


1.063 


1.031 


1.031 


1.031 


1.031 


. 1.031 


1.031 


1.031 


1.031 


1.036 


1.036 


1.031 


1.031 



THE NEW ENGLAND BAKING COMPANY 291 

The Massachusetts Workmen's Compensation 
Retrospective Rating Plan 

This plan will apply to Massachusetts Workmen's Compensation and Em- 
ployers Liability Insurance only. 

The factors applicable are these: 

Standard Premium (est.) 50,000 60,000 70,000 

Basic Premium 27.5% 26.5% 25.5% 

Minimum Premium 55.0% 53.0% 51.0% 

Maximum Premium 135.0% 133.0% 131.0% 

Loss Conversion Factor 1.15 1.15 1.15 

Tax Multiplier none none none 

The Incurred Losses used in calculating the Retrospective Premium will be 
the actual paid losses and the reserves, as estimated by the Gibraltar Company, 
for unpaid losses. 

The Reti'ospective Premium, subject to the Maximum and Minimum Retro- 
spective Premiums, will be the sum of: 

1. The Basic Premium and 

2. The Incurred Losses multiplied by the Loss Conversion Factor. 

Computation of the Retrospective Premium shall be made as in Plan D, 
except that provision is made for a final computation between June 30, 1958, 
and September 1, 1958. 

Fixed Price Plan 

The Fixed Price (or Guaranteed Cost Plan) will apply to: 

1. Workmen's Compensation and Employers LiabiHty Insurance for the 
states of New Jersey and Pennsylvania 

2. Comprehensive Liability Insurance in the state of New Jersey 

3. Massachusetts Statutory Automobile Liability Insurance 

4. All other elements of exposure above the limits of liability specified under 
Retrospective Rating Plan D above. 

Under this plan rates will be established in advance, and premiums will be 
developed by application of these rates to actual earned exposures. Rate 
levels will be keyed to the attainment of a desired dollar total within the frame- 
work of existing rate regulatory laws. 

Summary 

This proposal involves an unusual element— at no point does it identify a 
purchase price. Certain figures are presented as indications, but the absence of 
an over-all price tag may require explanation. 

Because of the importance of rate modifications in the development of 
initial premium charges and because of the many jurisdictions concerned in 
your case, the fact that their modifications are not yet published is of major 
importance. Obviously, any guesswork could produce deviations in terms of 
thousands of dollars. We hesitate to make such guesses. 

In short, we are urging you to adopt a principle, the value of which we 
believe we have demonstrated. 



case 



30 



GLOBAL CHEMICAL COMPANY 

Control of Research Expenditures 

This case presents the difficult problems of developing methods of 
control of research expenditures in a company and measuring the 
results of such expenditures. 

The Global Chemical Company was a medium-size concern spe- 
cializing in the development of products and processes both for itself 
and for other firms in the chemical industry. In some respects the 
company was a "job-shop" research laboratory for the chemical trade, 
and frequent requests were made to Global by other members of the 
industry for the development of a special product or process. The 
company maintained offices in the major cities throughout the United 
States. It also operated chemical plants in Amarillo, Texas; San 
Bernardino, California; Philadelphia, Pennsylvania; and Dubuque, 
Iowa, in which it produced a standard line of chemical products. 
Since the company's progress depended to a large extent upon its 
ability to tailor products and processes to meet the specific needs of 
customers, and to develop new products for its own organization, the 
research division was generally considered one of the most important 
operations of the company, and, as such, occupied a proportionate 
share of management's attention. 

In the spring of 1955 the Global management was reviewing the 
company's research activities with a view toward possible improve- 
ments in its control over research expenditures and in the appraisal 
of the profitability of its research program. 

Research Facility 

The facilities of the research division of the Global Chemical 
Company consisted of a group of buildings located on the outskirts 
of Baltimore, Maryland. The "central" plant housed most of the ex- 
ecutive staff and office personnel. Department heads also had their 
laboratories in this building, as did the chemical division head. A 
second building lioused the remaining scientific laboratories, while 

292 



GLOBAL CHEMICAL COMPANY 293 

a third housed pilot plant operations. Engineering development was 
carried on in a fourth building located adjacent to the other three 
facilities. 

Research Personnel 

Global employed over 200 research personnel in all: 90 were di- 
rectly connected with the research work, 33 were service personnel, 
60 were clerical workers, and the remaining 20 comprised the execu- 
tive group. 

Size of Research Program 

Some idea of the magnitude of Global's research activities may be 
gained from the fact that, for the three years 1952, 1953, and 1954, 
research expenditures ranged from $1.5 million to $1.8 million. Al- 
though the annual research expenditures had consistently amounted 
to about 3 per cent of sales, there was no company policy relating 
the amount of such outlays to expected sales revenues. 

Research Policy 

The general direction of the company's research activities came 
within the purview of its board of directors, who established broad 
company research policy and exercised general control over the 
program. In fact, the board had established a standing committee 
whose purpose was to maintain close contact with the research pro- 
gram through continued review and appraisal of the conduct and 
results of research operations. This committee, which consisted of 
the board chairman, the president, executive vice-president, director 
of research, and the chairman of the research committee, provided 
whatever guidance and direction it considered necessary to insure 
an effective research operation. Typical of the kinds of questions on 
which the standing committee offered guidance to the research di- 
vision were these: 

1. The question as to whether emphasis should be placed on the 
development of new products or on the improvement of existing ones. 

2. The determination of long-range research programs; that is, 
what particular fields of research might prove profitable in the long 
run? 



294 THE ROLE OF FINANCIAL ANALYSIS 

3. The question of when to intensify eflForts on a particular 
product and when to drop products for which the prospects ap- 
peared dim. 

4. The disposition of new products developed— for example, the 
appraisal of the sales potential of new products, the decision as to 
when a new item was ready to be turned over to an operating di- 
vision for production. 

5. The question of the potentials of by-products arising from new 
processes or products. 

Research Organization 

The division of research was headed by the director of research 
whose staff consisted of a controller, a purchasing agent, and a num- 
ber of department heads— one for each of the types of research shown 
in Exhibit 1 ( the Administration and Business department was in the 
charge of the research division controller ) . 

Budgeting Procedure 

The budgeting procedure at Global started at these department 
levels. Each department head prepared a budget using as a basis 
for his estimates the expenditures expected to be required during 
the budget period for projects already in progress and for those 
expected to be started during the year. In making these estimates 
the department head was guided by the advice and direction of the 
director of research who, in addition to his own thoughts, reflected 
the opinions and expectations of the standing research committee 
discussed earlier. The assistance of the research controller and his 
office was also available to department heads in the preparation of 
their budgets. 

Each departmental budget was broken down according to two de- 
tailed classifications : ( 1 ) by type of expense, as shown in Exhibit 3, 
and (2) by project, as illustrated in Exhibit 2. When the depart- 
mental budgets were completed, the research controller then com- 
bined them into a "master" budget, for research divisions as a whole, 
which also was broken down by two classifications of detail : ( 1 ) by 
type of expense, as shown in Exhibit 3, and (2) bv department, as 
shown in Exhibit 1. 

The master budget, after review by the company controller, was 
then submitted to the chairman of the research committee for pres- 



GLOBAL CHEMICAL COMPANY 



295 



KX II I BIT 1 

Analysis of Research Appropriation Program for 1954-1955 

Engineering research $ 300,000 

Organic chemical research 250,000 

Inorganic chemical research 110,000 

Maintenance services for research plant 375,000 

Product research 125,000 

Physics research 100,000 

Pilot plant research 100,000 

New product research 115,000 

Administrative and business department 95,000 

Total research appropriation $1,570,000 

entation to the research committee and board of directors for ap- 
proval and fund appropriations. 



Control of Expenditures 

Once the budgeting and appropriations procedure was completed 
in the Global company, close control was exercised in assuring that 
research expenditures were made in accordance with budget au- 
thorizations. Because the carrying out of a research project consisted 
primarily of the efficient utilization of research personnel, especially 
close watch was maintained over labor costs. No department head 
was allowed to commence a new project unless he could demonstrate 
that sufficient time for research was available to assure reasonable 
progress. Salary increases, and increases or decreases in research 
personnel, were made only after a careful analysis of the effects of 
the change on the division budget and on departmental budgets. 

EXHIBIT 2 

Research Division— Engineering Research Department 
Estimated Expenditures by Projects 





Number 


Estimate 1954-1955 


Title of Project 


Total 


Overhead 


Total 
Direct 


Labor 


All Other 
Direct 


Water Installation 
Improvement 

( No Project in 
1953-1954) 


342 


$18,352 


$8,300 


$10,052 


$8,000 


$2,052 



296 THE ROLE OF FINANCIAL ANALYSIS 

EXHIBIT 3 

Research Division Expense— Budget, 1954-1955 





Engineering Research Department 




Control 


Effective 
Monthly Salary 
Payroll as of 
■ ,_ , March 1, 1954 


Actual 
Budget Estimate Budget 8 Months 
1954^1955 1953-1954 1953-1954 1953-1954 


TOTAL EXPENSE-NET $ 


$ $ $ 


Income Credits 
Expense Transfers 





Total (excluding Income 

Credits ) 
Executive Labor ( $ ) 

Superv. and Clerical Labor ( $ ) 

Shop Direct Labor ( $ ) 

Research Labor ( $ ) 

Service Labor ( $ ) 

Overtime Salary Pay 

Power, Light, and Heat 
Maint. Material, and 

Service 
Raw Materials 
Operating Supplies 
Suggestion Awards 
Traveling and Expense 
Auto Depreciation and 

Insurance 
Auto Operating Expense c 

Auto Taxes 

Office Operating Expense 
Office Operating 

Appliances 
Dues, Subscriptions, and 

Memberships 
Telephone and Telegraph 
Professional Services 
Storage and Handling 

Expense 
Advertising ( Publications ) 
Payroll Taxes and Ret. 

Benefits 
Surveys 
Unclassified 
Taxes 
Insurance Premiums and 

Service 
Depreciation 
Rents and Rovalties 



GLOBAL CHEMICAL COMPANY 297 

The approval of the director of research was required for any 
addition of personnel to the research staff. Although the department 
heads could approve any requisitions for materials up to $250, any- 
thing above that figure had to be approved by the research controller, 
and requisitions amounting to over $500 had to be approved by the 
director of research. Finally, all requests for materials in excess of 
$1,000 and all maintenance and capital expenditures required the 
approval of the company treasurer. 

Expense Reporting 

A wide variety of reports was employed by the Global company 
in its efforts to control the cost of its research operations. Each de- 
partment head received a monthly report showing expenses, by 
project, for the month, for the year to date, and for the life of the 
project. Exhibit 4 illustrates the form of this report. The labor costs 
on this monthly report were supported by a detailed breakdown 
showing the time spent by each research worker on each project. 

A monthly report of actual versus budgeted expenses was also 
sent to the research committee along with a letter of transmittal 
explaining any significant differences between budgeted and actual 
costs. A monthly summary of expenses by accounts (as in Exhibit 
3 ) and for each department was also made to the director of research 
and the research committee. Exhibit 5 illustrates the form of this 
report ( account titles to be supplied in columns ) . Quarterly reports 
similar to the monthly reports were also submitted to the research 
committee, and with the quarterly report there was a written review, 
prepared by the director of research, describing progress to date and 
appraising the future prospects of each project. On the basis of this 
review the director of research and the research committee decided 
for each project whether it should be dropped, continued as planned, 
or modified in any respect. 

In addition to these monthly and quarterly reports, the research 
controller prepared interim reports for department heads when the 
expenses for a particular project had reached the budgeted limit 
or where it appeared that a project might run over its budget. On 
the basis of this report the department head might request additional 
appropriation to continue the study if further work appeared war- 
ranted by the results already accomplished. 



298 



THE ROLE OF FINANCIAL ANALYSIS 



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GLOBAL CHEMICAL COMPANY 



299 



EXHIBIT 5 

Monthly Expense Report to Department Heads 



CURRENT YEAR 













MONTHLY 


JUNE 










JULY 










AUGUST 










SEPTEMBER 










OCTOBER 










NOVEMBER 










DECEMBER 










JANUARY 










FEBRUARY 










MARCH 










APRIL 










MAY 




















CUMULATIVE 


MONTH 

OF 
JUNE 


BUDGET 










CURRENT 










LAST YR. 










2 MO. 

THRU 

JULY 31 


BUDGET 










CURRENT 










LAST YR. 










3 MO. 

THRU 

AUG. 31 


BUDGET 










CURRENT 










LAST YR. 










4 MO. 

THRU 

SEPT. 31 


BUDGET 










CURRENT 










LAST YR. 










5 MO. 

THRU 

OCT. 31 


BUDGET 










CURRENT 










LAST YR. 










6 MO. 

THRU 

NOV. 30 


BUDGET 










CURRENT 










LAST YR 










7 MO. 
THRU 
DEC. 31 












CURRENT 










LAST YR 










8 MO. 
THRU 
JAN. 31 


BUDGET 










CURRENT 










LAST YR 










9 MO. 

THRU 

FEB. 31 


BUDGET 










CURRENT 










LAST YR 










10 MO. 

THRU 

MAR. 31 


BUDGET 










CURRENT 










LASTYR 










11 MO. 

THRU 

APR 30 


BUDGET 










CURRENT 










LAST YR. 










12 MO. 
THRU 
MAY 31 


BUDGET 










CURRENT 










LASTYR 























300 THE ROLE OF FINANCIAL ANALYSIS 

At the end of the year, the controller prepared annual reports 
showing comparisons of budgeted against actual expenses along with 
the actual expenses for the previous year and the budget for the 
ensuing one. These reports included a review of the last year's op- 
erations with explanations of variations of actual from budget, both 
by type of expense and by project. 

In an effort to tie research in more closely with the actual produc- 
tion of its- products, the Global management was, in 1955, experi- 
menting with a new idea for guidance and control of its research 
program. Previously the costs of the research division had not been 
distributed either to product costs or to the operating divisions of 
the company. The division's expenses were, instead, shown in the 
company's income statement as a separate deduction. This practice 
had been based partially upon the premise that research benefited 
the company as a whole and partially upon the fear that the distribu- 
tion of research expenses among operating divisions might cause 
the company's research program to be unduly influenced by the 
special interests of divisional managements. Since such distribution 
would result in lower short-run divisional profit figures, there might 
be a tendency for division heads to oppose research expenditures 
that, in the longer run, would prove profitable to the company as a 
whole. The research director was aware of this apparent conflict of 
interests and, since he valued the cooperation of operating division 
heads very highly, he was eager to avoid any change that might an- 
tagonize them. 

The board of directors, however, was concerned about the over-all 
profitability of Global's research program. Although the directors 
knew that a certain portion of the company's research expenditures 
were directed to basic research and could not be readily prorated 
to specific products or divisions, it felt that there were some types of 
research that could be attributed to products or divisions. There was 
some feeling among the board members that if each product was 
made to bear its share of allocable research costs, the company would 
stand a better chance of a profitable research operation over-all than 
it now stood. The board felt, for example, that product development 
costs and the cost of pilot plant operations might well be distributed 
to products or producing divisions. Due to the significance of the 
research activity to the company's profitability and progress, how- 



GLOBAL CHEMICAL COMPANY 301 

ever, the board was extremely apprehensive lest it take action that 
would in any respect jeopardize the effectiveness of its research 
operations. 

Does Global Chemical Company exercise effective control over its 
research expenditures? 

Do you think GlobaTs research expenditures should be allocated to 
products and/or divisions? 



i 



ease 



31 



THE SOUTH AMERICAN COFFEE COMPANY 

Data for Management Use 

In this case the problem of measuring performance both for specific 
operating units and for functional areas, such as purchasing, is 
raised. 

The South American Coffee Company sold its own brands of coffee 
throughout the Midwest. Stock of the company, which was founded 
in 1903, was closely held by members of the family of the founder. 
The president and secretary-treasurer were members of the stock- 
owning family and other management personnel had no stock in- 
terest. An organization chart of the company is shown in Exhibit 1. 

Sales policies and direction of the company were handled from 
the home office in Cincinnati, Ohio, and all salesmen reported to the 
sales manager through two assistants. The sales manager and the 
president assumed responsibility for advertising and promotion 

EXHiniT 1 

Organization of the South American Coffee Company 



PRESIDENT 



SALES 
MANAGER 



VICE-PRESIDENT 
MANUFACTURING 



ASSISTANT 

GROCERY 

SALES 



ASST CHAIN a 

INSTITUTIONAL 

SALES 



SEC'Y-TREASURER 



CREDIT 



CONTROLLER 



PURCHASING 
AGENT 



FEDERAL 
TAXES 



GENERAL 
ACCOUNTING 



INTERNAL 
AUDIT 



FINANCIAL 
ANALYSIS 



PLANT MANAGER 

I 



PLANT MANAGER 
2 



PLANT MANAGER 
3 



302 



THE SOUTH AMERICAN COFFEE COMPANY 303 

work. Roasting, grinding, and packaging of coffee was under tl)e 
direction of the vice-president of manufacturing, whose office was in 
Cincinnati. 

The company operated three roasting plants throughout the Mid- 
west. Each plant operated on a profit and loss responsibility and the 
plant manager was paid a bonus on the basis of a per cent of his gross 
profit. Monthly profit and loss statements were prepared for each 
plant by the home office. The form of the profit and loss statement 
used is shown in Exhibit 2. Exhibit 3 shows the form of the com- 
pany monthly income statement. Each month the plant manager 
was given a production schedule for the current month and a tenta- 
tive schedule for the next succeeding month. Deliveries were made 
as directed by the home office. 

EXHIBIT 2 

Operating Statement 
Plant No. 1-April, 1952 

Net Sales ( Shipments at billing prices ) $74,462 

Less: Cost of Sales 

Green CofFee-at contract cost $37,366 

Roasting and Grinding: 

Labor $3,822 

Fuel 2,478 

Manufacturing Expenses 3,362 9,662 

Packaging: 

Container $8,462 

Packing Carton 914 

Labor 1,226 

Manufacturing Expenses 2,544 13,146 

Total Manufacturing Cost $60,174 

Gross Profit on Sales $14,288 

All financial statements were prepared in the home office, and 
billing, credit, and collection were done there. Each plant had a small 
accounting office at which all manufacturing costs were recorded. 
Plant payrolls were prepared at the plant. Green coffee costs were 
supplied each plant, as indicated later, on a lot basis. 

The procurement of green coffee for the roasting operations of the 
South American Coffee Company was handled by a separate pur- 
chasing unit of the company. Because of the specialized problems 
and the need for constant contact with coffee brokers, the unit was 



304 THE ROLE OF FINANCIAL ANALYSIS 

EXHIBIT 3 

Income Statement— April, 1952 



Net Sales 

Cost of Sales 
Green Coffee 
Roasting and Grinding 
Packaging 
Purchasing Department 



Gross Profit ■ • , $14,288 $ 247 $45,647 

Selling Expenses: 
Commissions 
Salaries 
Advertising 
Sales Travel 
Other 



Plants 


Green 
Coffee 


Total 


1 2 3 






$74,462 


$12,374 


$285,640 


37,366 

9,662 

13,146 


11,127 


142,168 

29,944 

60,041 

7,840 


$60,174 




$239,993 



General Expenses: 
Salaries 

Bonuses to Plant Mgrs. 
Printing and Stationery 
Dues and Subscriptions 
Depreciation on F. & F. 
Other 



Net Income— before Federal Income Taxes 
Provision for Federal Income Taxes 
Net Income— to Surplus 



located in the section of New York City where the green coffee busi- 
ness was concentrated. The purchasing unit operated on an au- 
tonomous basis accounting-wise, keeping all records and handling 
all financial transactions pertaining to purchasing, sales to outsiders, 
and transfer to three company-operated roasting plants. 

The primary function of the purchasing unit was to have available 
for the roasting plants the variety of green coffees necessary to pro- 
duce the blends which were to be roasted, packed, and sold to cus- 
tomers. This necessitated dealing in forty types and grades of coffee, 
which came from tropical countries all over the world. 



THE SOUTH AMERICAN COFFEE COMPANY 305 

Based on estimated sales budgets, purchase commitments were 
made which would provide for delivery in from three to fifteen 
months from the date that contracts for purchase were made. Al- 
though it was possible to purchase from local brokers for immediate 
delivery, such purchases usually were more costly than purchases 
made for delivery in the country of origin and, hence, these "spot" 
purchases were kept to a minimum. A most important factor in the 
situation was the market "know-how" of the purchasing executives, 
who had to judge whether the market trend was apt to be up or 
down and had to make their commitments accordingly. 

The result of all this was that the green coffee purchasing unit was 
buying a range of coffees for advance delivery at various dates. At 
the time of actual delivery, the sales of the company's coffees might 
not have been going as anticipated when the purchase commitment 
had been made. The difference between actual deliveries and cur- 
rent requirements was handled through "spot" sales or purchase 
transactions in green coffee with outside brokers or other coffee 
roasters. 

As an example, the commitments of the company for Santos No. 4 
(a grade of Brazilian coffee) might call for deliveries in the month 
of May of 20,000 bags ( of 132 pounds each ) . These deliveries would 
be made under fifty contracts which had been executed at varying 
prices from three to twelve months before the month of delivery. 
An unseasonal hot spell at the end of April had brought a slump 
in coffee sales, and it then developed that the company plants would 
require no more than 16,000 bags to meet their May requirements. 
The green coffee purchasing unit therefore had to decide whether to 
store the surplus in outside storage facilities (which would increase 
the cost) or to sell it on the open market. This example was typical 
of the normal operation. 

Generally speaking, the large volume of the company permitted it 
to buy favorably and to realize a normal brokerage and trading profit 
when selling in smaller lots to small roasting companies. Hence, the 
usual policy was to make purchase commitments on a basis of maxi- 
mum requirements— the usual result was that there was a surplus to 
be sold on a "spot" basis. 

In accounting for coffee purchases, a separate cost record was 
maintained for each purchase contract. This record was charged 
with payments for coffee purchased, with shipping charges, import 



306 THE ROLE OF FINANCIAL ANALYSIS 

expenses, and similar items, with the result that net cost per bag was 
developed for each purchase. Thus, the fifty deliveries of Santos No. 
4 coffee cited in the example would come into inventory at fifty 
separate costs. The established policy was to treat each contract on 
an individual basis. When green coffee was shipped to a plant, charge 
was made for the cost represented by the contracts that covered 
that particular shipment of coffee, with no element of profit or loss. 
When green coffee was sold to outsiders, the sales were likewise 
costed on a specific contract basis; there was resulting development 
of profit or loss on these transactions. 

The operating cost of running the purchasing unit was transferred 
in total to the central office, where it was recorded as an element in 
the general cost of coffee sales. 

For the past several years there has been some dissatisfaction on 
the part of plant managers with the method of computing gross 
profit subject to bonuses. This has finally led to a request from the 
president to the controller to study the whole method of reporting 
on results of plant operations and the purchasing operation. 

Write a brief analysis, directed to the controller, of any changes 
you would propose in the present monthly reporting procedure, 
giving reasons. You should base your analysis on the assumption 
that the bonus to plant managers will be retained. 



ease 



32 



ALBERTSON STEEL COMPANY 

Cash Procedure and Control 

In this case the problem of effective cash control for a decentralized 
company is examined. The question of viewing forms and procedures 
as a control device is balanced against consideration of decentral- 
ized management's subjective judgments. 

The Albertson Steel Company was a large steel producer and 
marketer with home offices in Chicago, Illinois. Tlie firm had plants 
in three states, and selling offices all over the world. In addition, 
Albertson maintained warehouses in principal cities throughout the 
United States. Their function was to service the local contractors 
and building materials firms. 

Albertson was organized on a geographic basis, and was divided 
into ten districts. Each district was in the charge of a divisional presi- 
dent who had the sole responsibility for his division, both for every- 
day decisions and for profits and losses. Long-range policies were 
directed from the home office in Chicago. 

The divisional presidents reported directly to the president of the 
parent company. The president of the parent company reported to 
the chairman of the Board of Directors and the directors. 

The president's staff consisted of vice-presidents in charge of sales, 
manufacturing, purchasing, and research, a treasurer, a secretary 
and general counsel, and a controller. These men were staff men who 
gave advice to the president and to their functional counterparts in 
the divisions. Each division president had a staff man whose job was 
similar to that of the central executives, except that division presi- 
dents did not have legal advisors, treasurers, or research department 
heads. These functional executives in the divisions were also staff 
men, and they reported to the president of the division. The func- 
tional relationship between home office and division was such that 
much cooperation and exchange of ideas occurred, and most sug- 
gestions were accepted by the divisions. However, there was no 

307 



308 THE ROLE OF FINANCIAL ANALYSIS 

compulsion on the part of the division executive to take the advice 
the Chicago office gave. 

Albertson did three basic types of selHng. The company sold to 
the large commercial trade; to construction companies; and, through 
its warehouses, to smaller users. Each type of sale was handled dif- 
ferently accounting- wise, although the branch ( usually a sales office 
under the supervision of one of the divisions) was responsible for 
the collection on the sale. All receivables were handled by the office 
that did the selling of the merchandise. 

Sales to large commercial users were similar to most such transac- 
tions: the merchandise was delivered, a receivable set upon the 
books of account by Albertson, and payment was made according 
to terms of the trade. In this type of sale Albertson carried the re- 
ceivable on its books for a length of time. 

Sales to construction companies were made on a "sight draft" 
basis, whereby the purchaser, in order to take possession of the 
goods, first had to pay for them. His payment to the bank entitled 
him to a release which he then presented to the railroad or ware- 
house in order to gain the use of the goods. 

Sales by the warehouses were similar to those made by the 
branches, with but one exception; the cash from such sales was 
deposited every day so that there was no ending balance of cash in 
the warehouse office's possession, other than regular petty cash funds. 

These three types of sales dictated the cash procedure for the 
branches and warehouses. Collections made by branch offices on 
sales to large commercial users were deposited in an account in a 
bank in their city. This account, although opened by the home office, 
was established as a divisional bank account, and could only be 
drawn upon by authorized divisional officers and/or employees. The 
account also could be closed only by the home office. 

When branches sold to contractors, a different procedure was 
followed because such sales were made on a "sight draft" basis. 
Albertson availed itself of a service rendered by The National City 
Bank of New York, known as the "Transcontinental Collection Sys- 
tem" for the collection of sight drafts. This system divided the United 
States into certain territorial districts based upon the general flow of 
money within those areas. The financial centers within those districts 
were designated as "concentration centers," for remittances were 
"concentrated" in principal banks in those cities from outlying banks. 



ALBERTSON STEEL COMPANY 309 

All concentration banks were linked to National City by private wire 
facilities. The drafts that were drawn by the office from which ship- 
ment is made were forwarded direct to a bank designated by the cus- 
tomer, with documents attached entitling the customer to obtain 
the goods. Upon receipt of the draft at the customer's bank, the 
customer was advised, and when he paid the draft, the documents 
were released to him. The funds were then transferred by the bank, 
in accordance with instructions appearing on the face of the draft, to 
a nearby concentration center bank where they were credited to a 
collection account maintained in such bank by the home office of 
Albertson. Copies of all drafts drawn were sent by the shipping 
office to the concentration bank. As the proceeds of the drafts were 
received at the concentration center bank and credited to the account 
of Albertson, the draft copies were stamped paid and returned to 
the branch office where they had been drawn. Upon receipt of the 
draft copies marked paid the customer's account was credited and 
the divisional office was advised of the total amounts deposited each 
day in each concentration center bank. To facilitate the collection of 
the funds and make them available immediately to Albertson, the 
customer's bank was requested to remit to the concentration center 
bank by draft drawn on a bank located in the same city as the con- 
centration center bank. As a rule, concentration centers were so lo- 
cated that it required no more than overnight mail service for a letter 
to arrive at the center from banks through which the drafts were 
collected. Advice of daily deposits and closing balances in the Al- 
bertson account at the various concentration center banks was wired 
to The National City Bank where the draft collections were sum- 
marized by divisions, and the summary, together with advice of the 
closing balances in each of the concentration center banks, was wired 
daily to the Albertson home office. Under this system Albertson had 
the use of the funds from collection of drafts within twenty-four 
hours after the time such funds were deposited in the various con- 
centration center banks. 

Cash receipts from warehouse sales and branch office collections 
were deposited daily in divisional depository bank accounts carried 
locally in the name of the division operating the warehouse or branch 
office. 

Daily reports of all collections, including both local collections 
deposited in divisional bank accounts and draft collections deposited 



310 THE ROLE OF FINANCIAL ANALYSIS 

to the credit of Albertson in concentration center banks, were pre- 
pared by each divisional office for forwarding to the home office of 
Albertson. These reports also showed the total of daily disbursements 
from divisional depository accounts and the balances at the close of 
business each day in all such accounts. A sample of the form of this 
daily report is given in Exhibit 1, from which the following specific 
examples are taken to illustrate the cash procedure of Albertson. 
The account at the Trust Company of Georgia represented the di- 
vision headquarter's depository bank account, and the other nine 
accounts were branch or warehouse depository accounts from which 
only the divisional headquarters could withdraw funds. Funds for 
the use of the branches or warehouses, or for use of the division 
headquarters office for payment of operating expenses, were main- 
tained in separate operating accounts. Funds must be transferred to 
the operating accounts by the divisional headquarters office, or by 
the home office of Albertson upon specific request from division 
executives. On June 10, 1950, the Savannah branch had an opening 
balance of $16,350. Deposits during the day from local sales or col- 
lections amounted to $5,120. Disbursements by the division head- 
quarters to an operating bank account for the use of the division 
amounted to $5,000 and, in addition, $3,000 was transferred to the 
division headquarters depository account in the Trust Company of 
Georgia, leaving a closing balance of $13,470. Transfers for the day 
from the division depository accounts to the home office depository 
account amounted to $75,000, advice of which was wired to the 
home office. Total deposits for the day in various depository accounts 
of the Southern Division were $61,426, of which $16,500 was used 
for operating purposes. The closing balances in the ten depository 
accounts of the division amounted to $230,654. The total of draft 
collections for the day in the Southern Division was $8,120, which, 
as noted, was deposited to the credit of Albertson at the First Na- 
tional Bank of Atlanta. 

The home office also used Exhibit 1 as the basis for its check and 
control over the balances maintained by the divisions. In order to 
control the total amounts in the division accounts, Albertson used 
the form shown in Exhibit 2. This form was posted every day and 
was completely up to date. It showed the total funds in all division 
depository accounts by divisional locations. It also showed the 
previous months' average daily balance, and, at the end of the cur- 



ALBERTSON STEEL COMPANY 311 

rent month, it contained the average daily balance for that month. 
The treasurer and assistant treasurer of Albertson were familiar with 
these figures and so could establish effective control by examining 
them each day. The total balance in Exhibit 1 and the division 
balance in Exhibit 2 would naturally be the same. 

The central office maintained control over its own bank accounts 
through the Daily Cash Report shown in Exhibit 3, consisting of two 
parts, one showing the flow of funds and the other the location of 
funds at the close of the day. In Section I the opening balance is 
presented, all receipts and disbursements shown, and the closing 
balance indicated. The receipts from the divisions would coincide 
with the disbursements of the division headquarters' bank shown in 
Exhibit 1 when the only withdrawal by the division has been in 
favor of the home office. Divisions remitted to the home office by 
transferring funds from their headquarters' accounts to the Albert- 
son depository account in the same or nearby bank. 

Section II of the report— Location of Funds— shows the cash bal- 
ances in the depository accounts maintained by the home office. This 
report also show^s the amount and disposition of borrowings, both 
from banks and through commercial paper loans. 

Bank accounts maintained for use of the home office were divided 
between depository accounts and operating accounts. Depository 
accounts were the principal reservoir in which available cash bal- 
ances of the company were carried, and from which amounts re- 
quired for operating purposes were withdrawn. A separate or spe- 
cific type of depository account were the collection accounts 
previously referred to, maintained in concentration center banks 
for the purpose of receiving proceeds of drafts covering shipments 
made by the various divisions. 

Operating accounts of Albertson were divided into three classifi- 
cations—the first type designated as "Operating Account" included 
those accounts in which amounts were deposited daily for withdrawal 
in payment of administrative expenses of the home office, such as 
legal fees, printing expenses, and miscellaneous office operating ex- 
penses and supplies. A second type of operating account was the 
"Payroll Account," which was operated on an imprest basis, the exact 
amount of each payroll being deposited in the account at the time 
wage and salary checks were drawn. The third type of operating ac- 
count was the "Dividend Account," separate accounts being main- 



312 THE ROLE OF FINANCIAL ANALYSIS 

tained for the payment of Common and Preferred dividends. These 
accounts were also maintained on an imprest basis, the amounts for 
dividends declared being deposited at the time dividend checks were 
prepared for mailing to stockholders. 

Section II of the report designates Location of Funds. (Exhibit 3 
shows the daily cash balances in each depository and collection ac- 
count maintained for the use of the home office.) In the summary 
showing bank totals (column 3) the balances in various operating 
accounts rounded out to the nearest full thousand dollars are also 
included. Balances in Payroll and Dividend accounts are omitted 
from the report because they were operated on an imprest basis. 
For example, at the Continental Illinois National Bank and Trust 
Company of Chicago the balance in the Depository Account is 
$190,032.02. The balance in the Collection Account is $120,915.86, 
and the balance in the Operating Account is $52,000.00. ( Figure not 
shown on report. ) Reference to this same section of the report will 
indicate that operating accounts were also maintained by Albertson 
at the First National Bank of Minneapolis, the First National Bank 
of New York, and others. 

The home office control over funds was exercised by the treasurer 
and his assistant. It was their responsibility to ascertain that the 
cash requirements of the company and of the divisions were met. 
They had the sole responsibility and authority for negotiating loans 
and for borrowing through commercial paper houses. They had 
direct control over the 32 depository accounts of the head of- 
fice and were responsible for the company's relations with all 196 
banks in which the company maintained either head office or divi- 
sional accounts. 

The company was acutely aware of its relations with the banks. 
It dealt with a great number of bankers. It borrowed great sums of 
money— up to $60,000,000 per year to finance inventory seasonals. It 
used the banks for collections, for credit, and many other types of 
information. 

Many company executives felt that good bank relations were of the 
greatest importance. Actually, Albertson was in so strong a financial 
position that, under normal conditions, it had no difficulty in obtain- 
ing loans : it had to ration them between its depository banks to keep 
them satisfied. The wisdom of this policy had been questioned, but 



ALBERTSON STEEL COMPANY 313 

the divisions and members of the home office felt strongly on this 
point. 

Even the commercial paper, of 30, 60, 90, or 120-day duration, 
had to be parceled out. The company, because of its strong financial 
position, was able to borrow on an unsecured basis for seasonal 
loans at rates quoted by its bankers for prime risks. Most banks 
quoted Albertson the same prime rate, but even if they did not, 
Albertson would not substantially change the distribution of its 
loans. The rate obtained by Albertson on commercial paper fluc- 
tuated with the market. Although it was usually cheaper than 
bank rates, Albertson did not use this method of financing exclu- 
sively. The paper it did issue, constituting approximately thirty per 
cent to forty per cent of its borrowings, was sold through brokers 
who had exclusive distribution rights within certain geographical 
territories. Such paper was sold to over 800 banks throughout the 
country. In this way, Albertson felt that it was accomplishing a 
public relations job with these small banks. The main problem in 
borrowing was to get an equitable distribution of funds which would 
retain the good will of the bankers. The banks purportedly kept the 
Albertson name to the forefront in the financial and trading circles 
in which the bankers were influential. 

The prevailing cash control system placed the responsibility for 
determining the adequacy of cash balances in divisional accounts in 
the hands of the division. The division controller estimated his daily 
needs at various branches and kept that much cash. If daily cash 
balances of the division exceeded cash requirements, the division 
was supposed to, and did, remit this amount to the home office. Ac- 
tually, less than 25 per cent of the company cash resided in the 
divisions. 

The major reason for division of responsibility for the funds was 
that the division, being closer to the actual operation, would be 
better able to determine its own needs. There were no formal rulings 
and no standards by which divisions were supposed to judge their 
needs. The relationship between home and division office was close 
and no friction occurred. The divisions were supposed to remit excess 
cash amounts to the home office. On the other hand, the home office 
rarely refused a request for funds, although it would scrutinize such 
requests, and even question them once in a while. The treasurer 
wrote few letters to the divisions asking for funds, but when he did, 



314 THE ROLE OF FINANCIAL ANALYSIS 

the response was usually favorable. One reason that divisions like 
to maintain balances reasonably larger than needed amounts, was 
to keep their banker good will. 

Divisions also had the responsibility, although they did consult 
with the home office, of determining what size the minimum balance 
should be in any particular establishment where it banked. This was 
also true of banks servicing the warehouses in the divisional confines. 
The decision was usually based upon the factor of service rendered 
by the bank to the company in the form of credit reports, loan 
balances, and activity of the account. Albertson had never computed 
the cost, if any, of the money tied up in this way. 

Exhibit 4 shows the average divisional balances by month from 
June, 1949, to March, 1950. Exhibit 5 shows the cash balances by di- 
visions at the end of each month for the period June, 1948, to Janu- 
ary, 1950. 



ALBERTSON STEEL COMPANY 



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ALBERTSON STEEL COMPANY 317 

EXHIBIT 3 

Section I— Daily Cash Report 

6272 G 0-1 4 49 2:30 p.m. Date Wednesday, June 10, 1949 
Opening Cash Balance Brought Forward $7,640,637.00 

Receipts Today 

Eastern Division 4,420.59 

Canada LTD - 

Southern Division 75,000.00 

Purchasing Department 11,210.11 

Central Division 684,423.66 

Ohio Division — 

Western Division 101,613.01 

Pennsylvania Division 425,030.00 

Utah Division 92.40 

Special Steel Division 29.59 

Miscellaneous 107,403.99 

Collection Accounts 367,405.04 

Notes Payable — 

Total Receipts Today 1,776,628.39 

Total Cash to Account For $9,417,265.39 

Disbursements Today 

Advances to: 

Eastern Division — 

Canada LTD - 

Southern Division — 

Purchasing Department 375,048.00 

Central Division 300,032.00 

Ohio Division — 

Pennsylvania Division — 

Utah Division 100,016.00 

Western Division 15,016.00 

Special Steel 100,016.00 

Home Office 100,016.00 

Notes Payable 75,000.00 

Miscellaneous 1,198.06 

Total Disbursements Today 1,066,342.06 

Closing Cash Balance Carried Forward $8,350,923.33 

Increase or Decrease from Previous Close $ 710,286.33 



EXHIBIT 3 (continued) 

Section II— Location of Funds 



Location 
of Funds 


Bank Acct. 
Name Type 


Notes Payable 


Cash Control 
Balances 


Bank Totals 

Including 
Oper. Accts. 


Minneapolis 


First National Dep. 


$ 300,000.00 


$ 414,149.93 


$ 470,149.93 




Northwestern Natl. Dep. 


300,000.00 


332,053.54 


383,599.09 




Col. 




51,545.55 




Chicago 


Continental 111. Dep. 
Col. 


300,000.00 


190,032.02 
120,915.86 


362,947.88 




First National Dep. 


300,000.00 


778,921.22 


916,786.18 




Col. 




137,864.96 




New York 


Bankers Trust Dep. 


300,000.00 


205,243.50 






Chase National Dep. 


300,000.00 


170,166.17 






Chemical Bk. & Tr. Dep. 


200,000.00 


113,486.92 






Corn Exchange Dep. 


200,000.00 


105,408.19 






First National Dep. 


400,000.00 


1,340,712.88 


1,384.712.88 




Guaranty Trust Co. Dep. 


300,000.00 


132,093.94 






J. P. Morgan Dep. 


300,000.00 


102,236.85 






National City Dep. 


300,000.00 


209,946.84 


393,217.06 




Col. 




183,270.22 






Now York Trust Dep. 


200,000.00 


163,030.69 




Atlanta 


First National Col. 


100,000.00 


213,353.53 






Fulton National Dep. 


100,000.00 


186,527.41 






Trust Co. of Ga. Dep. 


100,000.00 


182,351.54 




Boston 


First National Dep. 


100,000.00 


111,839.38 






Second National Dep. 


100,000.00 


124,272.84 




Buffalo 


M. & T. Trust Co. Dep. 


400,000.00 


162,123.49 




Cleveland 


Cleveland Trust Col. 
National City Bank Col. 




44,215.51 
93,059.74 




Dallas 


Republic National Col. 




77,775.88 




Detroit 


Nat'l Bank of Det. Dep. 
Col. 


200,000.00 


160,309.71 
81,660.71 


241,970.42 


Indianapolis 


Indiana National Dep. 




25,022.00 




Kansas City 


Commerce Trust Co. Dep. 
Col. 


100,000.00 


127,421.62 
32,226.35 


159,647.97 




First National Dep. 


100,000.00 


225,778.09 




Keokuk 


Security State Dep. 




116,945.97 




Louisville 


Citizens Fidelity Dep. 


200,000.00 


52,946.99 




Okla. City 


First National Dep. 
Col. 


200,000.00 


268,420.10 
95,506.83 


363,926.93 


Philadelphia 


Pennsylvania Co. Dep. 


100,000.00 


51,664.90 




St. Louis 


First National Dep. 
Col. 


100,000.00 


104,866.84 
62,476.94 


167,343.78 


San Francisco 


Bank of America Dep. 
Col. 


200,000.00 


283,781.93 
136,616.14 


420,398.07 




Crocker First Nat. Dep. 


200,000.00 
$ 6,000,000.00 


377,020.55 

$8,149,264.27 

1,496.49 




Total U.S. Banks 




Toronto 


Royal Bank of Can. Dep. 




Winnipeg 


Royal Bank of Can. Dep. 


600,000.00 


97,749.75 






Bank of Montreal Dep. 


710,000.00 
$ 7,310,000.00 


102,412.82 




Tot 


AL Bank Borrowings 




Con 


imercial Paper 


6,500,000.00 






Gr.^ 


ND Totals 


$13,810,000.00 


$8,350,923.33 





ALBERTSON STEEL COMPANY 



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case 



33 



THE WRIGHT KNIGHT COMPANY 

Measures of Performance 

This case deals with the problem of measuring divisional perform- 
ance in a decentralized manufacturing company. It presents a list 
of factors which one company considers important in judging per- 
formance and raises the question of establishing yardsticks by which 
these factors might be measured. 

The Wright Knight Company was one of the larger manufacturers 
of industrial products in the country. Sales were over $400,000,000 
annually, and profits after taxes had averaged $20,000,000 per year 
for five years. Investment in fixed assets stated before provision for 
depreciation totaled about $300,000,000. 

For five years the company had been in the process of changing 
its organizational operation from one of centralized control by its 
home oflBce to a decentralized operation. As a result of this change, 
the company then had forty-two departments reporting on a profit 
responsibility basis. These forty-two departments were grouped into 
five operation divisions, each headed by a company vice-president. 
The operating vice-presidents together with vice-presidents for fi- 
nance, law, industrial relations, and research and development re- 
ported to the president. 

The Problem 

Over a number of years complaints had been voiced by various 
company executives that they did not know the criteria by which 
their performance was judged. Comments were voiced that it ap- 
peared some executives were promoted because of their social skills, 
color of eyes, etc. This feeling that criteria were not developed and 
made known for appraising performance was heightened by two 
company policy changes. First, the decision to decentralize, putting 
forty-two department managers and five operating division heads 
more or less on their own, and, second, the decision to pay extra 

321 



322 THE ROLE OF FINANCIAL ANALYSIS 

compensation to key men (including the forty-two department 
heads) on the basis of "good performance." 

Early in 1953, the vice-president for finance asked his controller to 
study the problem of what criteria should be used in measuring per- 
formance at the department and division level. After a series of 
meetings, it was agreed that the approach the controller should take 
should be in the three following steps: 

1. Define the factors in company operations which were consid- 
ered important by the president and board of directors. 

2. Determine how to measure these factors. 

3. Set standards of performance. 

Over the following months, representatives of the controller's 
staff worked toward identifying the factors that operating and staff 
executives thought to be important in the conduct of company op- 
erations. The result of this preliminary study was a list of six factors 
which company executives considered the most important. These 
factors were: 

1. Profitability— return on investment 

2. Share of the market 

3. Plant efficiency 

4. Research and development 

5. Employee relations ' 

6. Public responsibility 

The six factors then had to be presented to the board for accept- 
ance as the criteria representing all the most important facets of 
company operations. 

The next step was to develop acceptable ways of measuring each 
of these factors. Some of the factors such as employee relations and 
public responsibility would require new imaginative attacks. Others, 
however, such as profitability, while appearing reasonably easy, had 
to be checked to see that the measure could not lead to improper 
inferences or appraisals of performance. 

What do you think of the factors selected by the controller and 
operating heads? Would you add others? 

How would you go about measuring performance in each of these 
areas? 



case 



34 



HYDROCARBON PRODUCTS COMPANY, INC. 

Transfer Pricing 

The Hydrocarbon case builds on the area introduced by the Wright 
Knight case. It is specifically concerned with a statement of company 
policy with respect to the setting of transfer prices at which divisions 
may bill other divisions of the same company for products in inter- 
divisional sales. The question of transfer pricing is considered as it 
relates specifically to determining the return provided by various 
divisions on the assets they employ. 

On December 9, 1954, the president of the Hydrocarbon Products 
Company, Inc., which had sales of around $75 mihion, announced 
that on January 1, 1955, the company would be reorganized into 
separate divisions. Until that time the company had been organized 
on a functional basis with the manufacturing, sales, finance, and re- 
search departments, each under one man's responsibility. Six divisions 
were to be set up, four by product group, and two by geographical 
area. Each division was to have its own production, sales, and ac- 
counting staff, and a general manager who would be responsible for 
its operation. The division's operating performance was to be judged 
by the profit it produced in relation to the investment assigned to it. 
It was anticipated that the procedure for computing the investment 
base and the return thereon would have to be carefully worked out 
if the resultant ratio was to be acceptable to the new division man- 
agers as a reasonable measure of their performance. 

One of the biggest obstacles to the establishment of the desired 
monthly profit and loss statement for each division was the pricing 
of products for transfer from one to another of the various divisions. 
At the time the divisions were established, the company's president 
issued a policy statement upon which a pricing procedure was to be 
based. The president's statement follows: 

323 



324 THE ROLE OF FINANCIAL ANALYSIS 

Subject: Pricing Policy for Transfer of Materials Between Profit 
Units 

Date Effective: January 1, 1955 

Statement of Policy 

The maximum, and usual, price for transfers between profit units is that 
price which enables the producing unit to earn a return on the investment 
required, consistent with what it can earn doing business with the average of 
its customers for the product group concerned. 

EstabHshed prices will be reviewed each six months or when a general 
change in market prices occurs. 

Discussion 

Pricing policy between operating units is particularly important because to 
the extent that the price is wrong, the return on one segment of the business is 
understated, and the return on another is overstated. This not only gives a false 
measure of how well individuals are performing, but may make for bad 
decisions on the business as a whole which will affect everyone. 

There are two possible relationships between a producing and consuming 
division. These are: ^ 

1. Supplier— Distributor , ', - 

2. Supplier— Convertor 

The elements of investment or expense which may not be found in intra- 
company relations are: 

1. Deductions for cash discounts, freight, royalties, sales taxes, customer 
allowances, etc. 

2. Usual selling expenses and in many cases order and billing services. 

3. Investment in Accounts Receivable. 

4. Investment in regular finished goods inventories where the consuming 
division buys special items to order. 

5. Certain customer services by the research laboratories, such as sales 
services where this applies. 

In both cases the producing division which acts as a supplier will establish 
a price for consideration by discounting his regular price structure for the 
elements listed above which apply. For the purpose of return on capital 
employed in Accounts Receivable, Inventories, etc., a 25 per cent rate will 
be taken. 

The heads of the buying divisions and selling division must agree on the 
pricing agreement established. In case of disagreement, the president will 
decide what is to be done. 



1 In the first relationship the buying division merely distributed the material pro- 
duced by the selling division. In the second case the buying division used the ma- 
terial in its production process so that it became part of a different product. 



HYDROCARBON PRODUCTS COMPANY, INC. 325 

Proposed Pricing Policy for Customers of the Blacksilver Division 

Statement of Company Policy: Pricing Policy for Transfer of Materials Between 

Profit Units. 

Approved by the President, 12/9/54 
Effective: 1/1/55 

"The maximum and usual price for transfers between profit units is that 
price which enables the producing unit to earn a return on the investment 
required, consistent with what it can earn doing business with the average 
of its customers for the product group concerned." 

"Established prices will be reviewed each six months or when a general 
change in market price occurs." 

Discussion: 

The President's policy sets forth return on investment on business done with 
average customers as being both the goal and the upper Kmit for an inter- 
divisional pricing policy. 

This proposal must have the mutual consent of the producing and distributing 
divisions before it becomes effective. The Financial Services Group ^ will advise 
whether or not the proposed pricing bases are workable ones before they are 
put into effect. Those areas where problems have not yet been resolved, or 
where we will proceed on a temporary trial basis, are pointed out as being 
subject to change. 

7 . Pricing: 

The Producing Division will charge the same price to another division as it 
charges to the average of its existing customers, less an allowance for those 
expenses incurred with average customers but not with interdivisional 
customers. These non-comparable expenses to be deducted include Sales 
Deductions,^ Investment in Inventories and Accounts Receivable (where 
necessary), and a part of Selling Expenses. The prices will be calculated in 
terms of a markup or multiplier factor on DMC for a product group. By 
product group we mean, for example, those fifteen code groups into which all 
our products are divided on the Gross Margin Statements (for example, #50, 
#70, etc.). A single markup on each product group will be recalculated and 
submitted each six months, based on the prior twelve months' experience with 
regular customers. 

It is expected that the billing arrangements will be as simple as possible, 
for example, a flat discount on a class of products is simpler than individual 
discounts on each product. 

The business between divisions can be thought of as a normal customer 
relationship and, as such, includes normal research and technical service on the 
product line unless specifically arranged for in another way. Special project 
research must obviously be specifically negotiated. 



A staff group under the company's treasurer and controller. 
These included freight, royalties, and sales taxes. 



326 THE ROLE OF FINANCIAL ANALYSIS 

We are hopeful that this policy will work out equitably giving each division 
a fair basis for the business they do. If in practice it is found that the policy 
is not working properly, is complicated in its application or calculation, or is 
working a hardship, the policy will have to be changed. 

The largest of the newly formed divisions, the Blacksilver Division, 
was strongly affected by the problem of transfer prices since about 
13 percent of its sales would be to other divisions. The establishment 
of transfer prices could be done in several ways. They could be based 
on the current market price reduced by amounts reflecting the five 
"elements of investment or expense which may not be found in intra- 
company relations," as listed in the president's policy statement. 
Another method would be to use direct manufacturing cost (DMC) 
as a starting figure, with some sort of markup added to fix the sales 
price. 

With only three weeks before the separation into divisions, it was 
important that a schedule of prices be established quickly for the 
transfer of products between divisions. The Blacksilver Division's 
task was vastly complicated by its large number of products. There 
were several hundred different compounds and materials for which 
a price had to be fixed. It was, therefore, partly for the sake of ex- 
pediencv that the Blacksilver Division chose to set the prices on the 
basis of direct manufacturing cost. The figures used in this method 
were more readily available than those used in setting a price based 
on the current market price. Furthermore, the system was susceptible 
to a grouping of products, thereby eliminating a large number of 
calculations. The division's products could be divided into fifteen 
groups of related items, each group to be handled as a unit for set- 
ting transfer price markups. In addition periodic profit and loss state- 
ments could be made for each group. 

A week after the president' policy statement on transfer pricing 
had been distributed, the Blacksilver Division issued the following 
interpretation of the policy which stated the proposed method for 
setting prices for the sale of products by the Blacksilver Division to 
other divisions. 

For example, the selling price of Product Group #70 to the For- 
eign Sales Division for the second half of 1954 would have been cal- 
culated as follows: 



HYDROCARBON PRODUCTS COMPANY, INC. 327 

1. Compute prior twelve-month DMC to Regular Customers for each 
Product Group: 

Second half 1953, first half 
1954 Sales of #70 to: 

Customers ($000) $500 100% 

Direct Manufacturing Cost 350 70 

$150 30% 

Markup to Regular Customers = 1.43 times (100 ^ 70) 

2. Deduct Noncomparable Expenses from Selling Price to get new multi- 
plier for inter divisional Sales: 

Sales Deductions 1.0% 

Accounts Receivable 

(25% average company return X 30 days average receivables = 2.0% 

360 days in 100% sales year 

, Selling Expenses (Product average of 4.4% less 10% 
for those expenses incurred for the benefit of all 
divisions ) 4.0% 

Total 7.0% 

100 - 7.0% = 1.33 times 



70% 

3. Apply this markup to the DMC of each product in the product group as 
it is sold to the Foreign Sales Division. 

The above steps will be the general rule for calculating our prices to other 
divisions. Exceptions to this procedure may arise under the following conditions: 

a. If sales of a product to regular customers out of one of the producing 
plants for the twelve-month period are too small to provide a reliable base for 
calculating the markup for that group, then sales of all producing plants of 
the division for the twelve-month period will be used. 

For example, in the last twelve months, sales of the #50 group were $2,340. 
This small amount is subject to too wide a margin of error to use as a base for 
pricing a much larger Foreign Sales Division volume. Therefore, U. S. Domestic 
Sales would be used, which were around $50,000 for 1954. 

When sales volume for any one product group out of any one plant is less 
than $10,000 for twelve months, then sales from all three U. S. Plants will be 
used as a base. 

b. If a group of products with no domestic equivalent is produced only for 
sale to another division of the company, a selling price will be negotiated 
directly. 

c. When materials are sold to another division in a semi-finished state, a 
selling price will be negotiated in place of the above formula, except where 
these semi-finished goods differ from finished goods in name only. 

d. In some cases raw materials are supplied from one division to another to 
give the receiving division the benefit of quantity purchase and duty benefits it 



328 THE ROLE OF FINANCIAL ANALYSIS 

would be otherwise unable to obtain. In these cases the supplying division will 
charge only the actual cost of the materials, plus an appropriate charge to 
reflect cost of handling, receiving warehousing, investment, and purchasing, 
but no profit. 

On April 25, 1955, the company's president announced a revised 
statement of interdivisional pricing policy. The new policy empha- 
sized negotiation as a basis for establishing transfer prices rather 
than maintenance of a rate of return. 

One of the reasons for restating the policy lay in a difference of 
opinion which arose between the Blacksilver Division and the Re- 
fined Products Division over the prices the latter established or 
products it was selling to the Blacksilver Division. Almost 20 percent 
of the Refined Products Division's sales were to other divisions, 
making interdivisional sales an important part of its business. At the 
time Hydrocarbon Products Company was reorganized into divi- 
sions, the Refined Products Division was operating at a loss, whereas 
the Blacksilver Division was making a reasonable profit. In the dis- 
cussion of prices a question arose on the interpretation of the presi- 
dent's first paragraph in his statement of policy. The Refined 
Products Division wished to charge a price to the Blacksilver 
Division which would yield a return comparable to the return the 
Blacksilver Division was making. The latter replied that the rate of 
return used should be that of the producing division, which in this 
case was negative. The Refined Products Division, however, would 
not agree to this, because, they said, they would be unduly penalized 
by the unfavorable nature of the rest of their business. They would 
never be able to make any money selling within the company to 
other divisions. 

After settling this controversy by arbitrarily setting a transfer 
price for this instance, the president decided that the transfer price 
policy should not use the rate of return on investment as a basis for 
pricing, but rather that the determination of transfer prices should 
be left to negotiation between division managers. Therefore, in order 
to clarify this and also to add some detail to the description of pos- 
sible relationships between the buying and selling divisions, the 
following policy statement was substituted in April, 1955, for the 
original one issued in December, 1954. 



HYDROCARBON PRODUCTS COMPANY, INC. 329 

Subject: Pricing Policy for Transfer of Material Between Profit Units 
Date Effective: July 1, 1955 

Statement of Policy 

The prices to be charged, or fees or commissions allowed on the transfer of 
materials between divisions are to be negotiated in good faith within the limits 
set forth below, and with the intention that they shall be fair to both divisions 
and in keeping with the multiple profit concept of the company. 

Established prices, fees, or commissions will be reviewed each six months, 
or when a general change in market prices occurs. 

Discussion 

There are four cases involving prices or commissions between divisions. 

1. "Raw material" 

2. Partially Finished Products 

3. Resales 

4. Commissions 

''Raw Maferiar 

This is a material which the buying division consumes in the manufacture 
of its products. In addition, it is a finished product, or is closely related to a 
finished product, made and sold by the producing division. 

The pricing policy for Raw Material is not intended to: 

a. Give the buying division a price advantage over what it could buy for 
from the outside if it were a free agent, nor 

b. Give the producing division an expense advantage because it is selling 
inside the company. 

The price is to be arrived at by negotiation. In those cases where the material 
is regularly made and sold to the outside, it is expected that the price shall 
not exceed the lowest net sales price then currently being invoiced by the 
producing division to any manufacturer for the product in similar containers 
and in like quantity of total annual purchases, irrespective of quantity shipped 
at any one time. 

To offset the expense advantage which the producing division gets from 
"inside" sales, the president will determine, after discussions with the producing 
division, the amount of the savings which will be charged to the producing 
division and credited to a central department. 

Nothing in this policy for raw material makes it necessary for any division 
to agree to buy from any other division, and, likewise, there is nothing which 
makes it necessary for any division to agree to sell to any other division unless 
both divisions are entirely satisfied with the arrangements. 

Partially Finished Product 

This is a partly finished product of the producing division not offered for 
sale as such, not available from outside sources, and consumed by the buying 



330 THE ROLE OF FINANCIAL ANALYSIS 

division in the manufacture of its products. The interdivisional price for these 
materials is to be negotiated. 

Resales 

These are products produced and sold by one division and bought from the 
producing division by the buying division for resale. This applies primarily 
to the Foreign Sales Division where, in general, they have responsibility for 
all merchandising and pricing policies in their area. The interdivisional price 
for these products is to be negotiated. 

Commissions 

These are paid to the Southern Division for the sale of any product in its 
territory which it does not manufacture. The Southern Division has exclusive 
distribution rights and is completely responsible for all sales, accounts re- 
ceivable, inventories, and personnel in its territory. The commission will be 
negotiated by the divisions involved. 

General • 

In setting prices, commissions, and fees between divisions, it is particularly 
important that they be right, because to the extent that they are wrong the 
return to one division is understated and the return to the other is overstated. 
This not only gives a false measure of how well divisions are performing, but 
may lead to bad decisions which will affect everyone. 

In the case of partially finished products, resales and commission arrange- 
ments, the price or commission negotiated must take into consideration the 
following : 

a. The buying division is not free to purchase on the outside. 

b. An incentive should be provided the buying division to insure aggressive 
promotion and sale of the products. 

c. The producing unit should earn a return on the investment involved 
which is consistent with what it can earn (with that product group) 
doing business on the outside. 

d. Those items of investment or expense not involved in the interdivisional 
transfer, such as: 

1. Deductions for cash discounts, freight, royalties, sales taxes, customer 
allowances, etc. 

2. Selling expenses and, in many cases, order and billing services. 

3. Investment in Accounts Receivable and in regular finished goods 
inventories where the consuming division buys special items to order. 
A 25 per cent return will be used until December 31, 1955, at which 
time a new rate will be set. 

4. Certain customer services of the research laboratories as sales services 

where this apphes. 

In the negotiations, both the buying and selling divisions will document 
their basis for any offer or counteroffer. 

In cases where satisfactory arrangements cannot be negotiated, the president 
will decide what is to be done in all cases except Raw Material. 



HYDROCARBON PRODUCTS COMPANY, INC. 331 

At the time when this revised statement of company pohcy was 
circulated, the Blacksilver division did not make any changes in its 
statement of interpretation. 

The accounting problems involved in providing separate profit 
and loss statements were not easily solved. There had been little 
time for preparation of the accounting structure, and the many 
hundreds of different products involved in transfers between divi- 
sions made the accounting for these transfers a major monthly task. 
Though the multiplier for all products within a group was the same, 
each individual product's direct manufacturing cost and monthly 
volume had to be recorded. The desire of those involved in establish- 
ing a workable system was reflected by one man's statement that 
they wanted to "wrap up the package and be done with it." It was 
expected that once the prices were agreed upon, direct manufactur- 
ing cost figures would be examined quarterly for any necessary 
changes, but that the multiplier would not be changed as often. 

After the system had been operating about a year, situations began 
to arise which required special consideration. One of these con- 
cerned Foreign Sales Division which was purchasing a certain 
chemical in bulk from the Blacksilver Division for resale to Germany. 
Using the multiplier formula to establish the transfer price, and 
adding the Foreign Sales Division's costs of distribution, the Foreign 
Sales Division found they were priced out of the German market 
by about 6 per cent. If a lower transfer price could be established, 
permitting the Foreign Sales Division to compete in the German 
market, a significant additional volume could probably be secured 
from several large customers. After discussing the problem at length 
the managers of the two divisions decided to set a special price for 
these large German customers and to account for the shipments 
separately from the other shipments of products within the product 
group. 

A similar problem appeared when the Foreign Sales Division pro- 
tested the transfer price of another product. Since the multiplier for 
a product group was based on the weighted average of the markups 
for all outside sales the previous year, it was possible for the transfer 
price of a product to look high or low when compared to the actual 
outside selling price. Furthermore, it could not be argued by the 
selling division that any inequity would balance out, since within a 
group the mix of products which were transferred to another divi- 



332 THE ROLE OF FINANCIAL ANALYSIS 

sion might not be the same as the mix on which the multipHer was 
based. 

Another type of problem arose when the Southern Division man- 
ager came to the manager of the Blacksilver Division with a pro- 
posal concerning a compound which Blacksilver had been producing 
and selling to the Southern Division for distribution. At the time of 
divisionalization the products which each division would produce 
were agreed upon. However, this particular compound was not 
covered specifically, and since it was a fairly simple compound to 
produce, it was possible for other divisions besides Blacksilver to 
produce it. The Southern Division was one of these and had idle 
facilities to do it. 

The Southern Division manager stated that he wished to change 
the allocation of the total company markup between his division 
and the Blacksilver Division. With the present transfer price he re- 
ceived 20 per cent of the total markup over direct manufacturing 
cost, and the Blacksilver Division received 80 per cent. Now he 
wished to receive 70 per cent, leaving 30 per cent for Blacksilver. 
This markup, he said, was reasonable since the 30 per cent would 
still represent contribution to overhead and profit of the Blacksilver 
Division, which already had excess production capacity for the 
compound. 

The request was prompted by the Southern Division's receipt of 
a new standing order at a slightly reduced price for an amount two 
and one-half times the division's present sales of the compound. The 
Southern Division manager stated that to accept the order, either 
the price to the division had to be lowered, or the division would 
produce the compound itself. The increased volume made it eco- 
nomically feasible for the Southern Division to use its idle produc- 
tion facilities. 

Another situation arose in connection with a special compound 
"G" which the Blacksilver Division produced and sold to one large 
domestic user, several small domestic users and, through the For- 
eign Sales Division, to the overseas market. Sales of the compound 
were among the largest of any single product and represented about 
one-third of the division's sales to the Foreign Sales Division. 

One of the major ingredients of compound G had been purchased 
from one large supplier who, because of the technical requirements, 
had to make special production runs. In the spring of 1957, after 



HYDROCARBON PRODUCTS COMPANY, INC. 333 

considerable searching and development work, a new supplier was 
found who could supply the major ingredient at a 20 per cent lower 
price, which would reduce the Blacksilver Division's direct manu- 
facturing cost by almost 10 per cent. Considerable discussion fol- 
lowed as to what effect this would have on the price at which com- 
pound G was transferred to the Foreign Sales Division. 

The contract which the Blacksilver Division had with the one 
large domestic user of compound G stated that the price would be 
based on Blacksilver's manufacturing cost. With the new supplier 
and the lower manufacturing cost, the price to this customer would 
have to be reduced. The price to other domestic users was not con- 
tractually related to cost so Blacksilver was free to maintain its 
selling price, and thereby receive a larger profit. 

The price at which compound G would be transferred to the 
Foreign Sales Division was not so easily settled. If the established 
multiplier formula were retained, the transfer price would be re- 
duced and Blacksilver would lose the benefit of the work to find 
and develop the new supplier. On the other hand, if the formula 
were to be changed and the old price maintained, the question arose 
as to what the new basis would be. Thus far the multiplier had been 
based on a full year's cost and sales experience with outside cus- 
tomers, and, unless this procedure were changed, the multiplier 
would not reflect fully the new cost for a year. Thus a projection of 
costs would have to be made, if any change in the multiplier were 
made now, and the basis of the projection and any subsequent ad- 
justments to it would be subject to much debate. Furthermore, if 
such a change were allowed once with all its associated accounting 
complications, there could easily be many other adjustments brought 
up for consideration. "Such shifting from one pocket to another," 
said one man in the Blacksilver Division, "can take a lot of time." 



case 



35 



BIRCH PAPER COMPANY 

Administering Transfer Price Policy 

The Birch Paper Company case also Involves the question of transfer 
pricing as it relates to the use of the concept of return on investment 
in measuring performance of divisions. This case raises the problem 
of reconciling conflicts which may arise between the Interests of a 
particular division and the company as a whole. 

"If I were to price these boxes any lower than $480 a thousand," 
said Mr. Brunner, manager of Birch Paper Company's Thompson 
division, "I'd be countermanding mx^rder of last month fo r_our 
salesmen to stop shaving their bids and to bid full cost quo tations . 
I've been trying for weeks to improve the quality of our business, 
and if I turn around now and accept this job at $430 or $450 or 
something less than $480 I'll be tearing down this program I've been 
working so hard to build up. The division can't very well show a 
profit by putting in bids which don't even cover a fair share of 
overhead costs, let alone give us a profit." 

Birch Paper Company was a medium-sized, p aitly in^grated 
paper compa^^jrodijcing, white an d kraft papers and paperboard. 
Apportion qfJts_.paperboaTd_outpiitjs^^ corrugated 

boxes by the Thompson division, which_^koj3rinted_jLnd^ 
the outsid e^surtace^gtS^^boxes. Including Thompson, the company 
had four producing divisions and a timberland division which sup- 
plied part of the company's pulp requirements. 

For several years each division had^^ee n judged in dependently 
on the basis of its profit and refurn on investment. Top management 
had been working to gain effective results from a policy of decen- 
tralizing responsibility and authority for all decisions but those re- 
lating to over-all company policy. The company's top officials felt 
that in the past few years the concept of decentralization had been 
successfully applied and that the company's profits and competitive 
position had definitely improved. 

In early 1957 the Northern division designed a special display box 

334 



BIRCH PAPER COMPANY 335 

for one of its papers in conjunction with the Thompson division 
which was equipped to make the box. Thompson's package design 
and development staff spent several months perfecting the design, 
production methods, and materials which were to be used. Because 
of the unusual color and shape these were far from standard. Ac- 
cording to an agreement between the two divisions, the Thompson 
division was reimbursed by the Northern division for the cost of its 
design and development work. 

When the specifications were all prepared, the Northern division 
/ asked for bids on the box from the Thompson division and from two 

/ outside companies. Each division manager was normally free to buy 
from whichever supplier he wished, and even on sales within the 

\ company, divisions were expected to meet the going market price 

\ if they wanted the business. 
\ In early 1957 the profit margins of converters such as the Thomp- 
son division were being squeezed. Thompson, as did many other 
similar converters, bought its board, liner, or paper and its function 
was to print, cut, and shape it into boxes. Though it bought most of 
its materials from other Birch divisions, most of Thompson's sales 
were to outside customers. If Thompson got the business, it would 
probably buy the liner board and corrugating medium from the 
Southern division of Birch. The walls of a corrugated box consist of 
outside and inside sheets of linerboard sandwiching the fluted cor- 
rugating medium. About 70 per cent of Thompson's out-of-pocket 
cost of $400 represented the cost of linerboard and corrugating 
medium. Though Southern had been running below capacity and 
had excess inventory, it quoted the market price which had not 
noticeably weakened as a result of the oversupply. Its out-of-pocket 
costs on both liner and corrugating medium were about 60 per cent 
of the selling price. 

The Northern division received bids on the boxes of $480 a 
thousand from the Thompson division, $430 a thousand from West 
Paper Company, and $432 a thousand from Eire Papers, Ltd. Eire 
Papers offered to buy from Birch the outside linerboard with the 
special printing already on it, but would supply its own inside liner 
and corrugating medium. The outside liner would be supplied by the 
Southern division at a price equivalent of $90 per thousand boxes, 
and would be printed for $30 a thousand by the Thompson division. 
Of the $30, about $25 would be out-of-pocket costs. 



336 THE ROLE OF FINANCIAL ANALYSIS 

Since this situation appeared to be a little unusual, Mr. Kenton, 
manager of the Northern division, discussed the wide discrepancy of 
bids with Birch's commercial vice-president. He told the commercial 
vice-president, "We sell in a very competitive market where higher 
costs cannot be passed on. How can we be expected to show a decent 
profit and return on investment if we have to buy our supplies at 
more than 10 per cent over the going market." 

Knowing that Mr. Brunner had on occasion in the past few months 
been unable to operate the Thompson division at capacity, it seemed 
odd that Mr. Brunner would add the full 20 per cent overhead and 
profit charge to his out-of-pocket costs. When asked about this over 
the telephone, Mr. Brunner's answer was the statement which ap- 
pears at the beginning of the case. He went on to say that having 
done the developmental work on the box, and having received no 
profit on that, he felt entitled to a good markup on the production 
of the box itself. 

The vice-president explored further the cost structures of the 
various divisions. He remembered a comment the controller had 
made at a meeting the week before to the effect that costs which for 
one division were variable, could be largely fixed for the company 
as a whole. He knew that in the absence of specific orders from top 
management, Mr. Kenton would accept the lowest bid which was 
that of the West Paper Company for $430. However, it would be 
possible for top management to order the acceptance of another bid 
if the situation warranted such action. And although the volume 
represented by the transactions in question was less than 5 per cent 
of the volume of any of the divisions involved, other transactions 
could conceivably raise similar problems later. 



case 30 

LONG MANUFACTURING COMPANY 

Allocation of Assets to Decentralized Divisions 

This case raises the question of allocating a company's investment 
in research and development facilities to its various divisions, again 
in connection v/ith the use of the concept of return on investment 
in measuring performance. Administrative questions as v/ell as prob- 
lems of technique are involved. 

The Long Manufacturing Company with 1956 sales of just over 
$100,000,000 operated six plants which produced different but re- 
lated products for sale to other companies or consumers. Each plant 
was operated independently by a plant manager whose performance 
was judged by several factors, one of the most important of which 
being the return the plant made on the investment which had been 
allocated to it. 

The investment figure used in the calculation had, since the system 
was started, included all the investment over which each plant man- 
ager had control. Until the spring of 1957 there were two classes of 
investment which were not included in the divisions' investment 
base: headquarters investment and research investment. The former 
was small ( .2 per cent of the company's total net investment ) since 
most of the headquarters' facilities were rented. Research investment 
had until recently also been small, but by the spring of 1957 had 
grown to just over 1 per cent of the company's total net investment, 
and it was expected that more money would be invested in research 
facilities in the near future. 

In late 1956, the president of Long Manufacturing Company 
asked that all the company's investment be distributed in some way 
to all the operating divisions. This would, he stated, make the re- 
ported return on investment by the plant more realistic as indicators 
of how well the company as a whole was doing. 

The recommended method of distribution of investment was to 
be based initially on the allocation of expenses. Distributed invest- 
ment would bear the same relationship to total investment as allo- 

337 



338 THE ROLE OF FINANCIAL ANALYSIS 

cated expenses bore to total expenses. If a division had 20 per cent 
of total research expenses allocated to it, it would carry a 20 per cent 
of total research investment. The allocation of expenses for both 
research and headquarters activities was in turn according to a 
simple average of three weighting factors: net realization, or sales 
less freight and discounts; net book value of the property assigned 
to the plant; and payroll or total salaries and wages. Thus, if a divi- 
sion had 10 per cent of the company's total net realization, 9 per 
cent of total net book value of property, and 14 per cent of the di- 
rectly assignable payroll, the division would be allocated 11 per cent 
of the headquarters and research expenses. It would also now be 
allocated 11 per cent of the research and headquarters investment. 

One exception to the allocation of research expenses by formula 
occurred in the case of expenses which were in the nature of techni- 
cal service costs. These were charged directly to the plant for which 
the work was done. In theory this exception had seemed reasonable; 
in practice, however, the line separating technical service from re- 
search was difficult to define. 

A memorandum was issued to all plants early in 1957 explaining 
the forthcoming allocation of headquarters and research investment. 
The memorandum made the following statements about the alloca- 
tion of research investment: 

Allocation of Total Gross Investment to Plants 

Currently the plants do not include in their operating investment base aiiy 
of the facilities that serve the entire company, for example, research. Inclusion 
of these facilities will mean that the operating return on investment should now 
measure the performance of the total assets in the company. 

Recommended Method of Allocation of Research Investment to Plants 

Distribution on the Basis of Research Expense: This makes use of readily 
available figures and adds a measure of flexibility, for distribution depends on 
the annual budgeted research expenses. This incorporates a measure of their 
"value received" from research during the year. Over a period of time allocation 
of the research gross investment will be improved as more precise expense 
figures are developed. 

Soon after this memorandum was issued, the financial analysis 
manager received a letter from one of the division managers which 
said in part: 

... I (question the advisability of allocating research investment to the divisions. 
As you know, we exercise no direct control over research expenditures and, 



LONG MANUFACTURING COMPANY 339 

consequently, we are unable to control the effect of increased research invest- 
ment on our return. It seems to me the return on investment concept will be a 
more meaningful tool to the divisions if olk* investment base includes only those 
items over which we have some degree of control. . . . 

The financial manager knew that, though it was the company's 
research director who actually planned what was to be worked on by 
his research staff, the plant managers did have some influence on the 
research director's decisions through periodic discussions with him. 
Furthermore, two of the plant managers were on the board of di- 
rectors and in directors meetings could exercise some influence over 
the choice of research projects. 

With these facts in mind the financial analysis manager wrote an 
answer to the plant manager's letter. This read in part as follows : 

Letter to a Division Manager from Financial Analysis Manager 

. . . The major item that had not formerly been carried by the plants in their 
investment base is the investment in research. The reason that this is now 
included is so that returns will be based upon the total investment in the com- 
pany. We do not believe that the company could long exist without research. 
And, we believe that the plants and products they produce benefit from this 
research and should therefore carry their share of such investment. 

Your point on exercising direct control over research investment is well taken. 
However, I do not feel that this is an issue and I do question the impHcation 
that a plant manager has no degree of control over research. 

Return on investment is an analytical tool that we have tried to make uni- 
formly applicable to as many general and specific problems as possible. We 
have attempted to make it equally applicable in measuring past performance 
and providing a guide for current problems, as well as giving a basis for 
decisions a£Fecting the future. It is not a perfect yardstick, but it does come 
close. 

There is no reason why this tool cannot be designed by plant management 
to serve its particular purposes at any level within the plant. I am thinking 
here of plant managerial control and would be glad to work with you on this. . . . 

What position would you take on this question? 
How do you react to the financial manager's letter? 



ease 



37 



BORAH PETROLEUM COMPANY 

Analyzing and Reporting Operating Results 

The Borah Petroleum case deals with the problem of summarizing 
and communicating to top management the results of a company's 
operations. The case provides a springboard for a discussion of the 
broad question of reporting to management. 

The controller of the Borah Petroleum Company was setting up 
a new "control book" which would summarize key data for the 
executive committee comprising members of top management. 

Exhibit 1 is a comparison of 1954 and 1955 operating results for 
one sales district. District managers had used this form for twenty 
years. Analysis in this detail for thirty sales districts, however, was 
thought to be too much for the top management group. 

The controller proposed condensing the comparison for each dis- 
trict to a statement of the increment in profit broken down by causes 
of variation. His first attempt to break the change in net profit down 
by causes is shown in Exhibit 2. The causes considered were volume, 
price per gallon, costs per gallon (exclusive of marketing cost), 
product mix, and marketing cost. Change in net profit due to volume 
equaled the change in over-all gallon volume times the 1954 net in- 
come per gallon. Price, cost, and mix effects were combined in the 
calculation of profit change due to gross margin (change in gross 
margin per gallon times 1955 gallon volume ) . Change due to market- 
ing costs equaled change in marketing cost per gallon times 1955 
gallon volume. 

Gross margin change was broken down in turn into price, cost and 
mix change. Price change was calculated by multiplying the change 
in price per gallon for each product by the corresponding 1955 gallon 
volume and adding algebraically the resulting changes for all prod- 
ucts. Cost change was calculated in the same way.^ Mix change was 

^ Throughout the exhibits, a figure in parentheses indicates a decrease from 1954 to 
1955 in the absohite magnitude of the figure in question, whether for example, it be a 
price figure (causing a reduction in profit) or a cost figure (causing an increase in 
profit). 

340 



BORAH PETROLEUM COMPANY 341 

found by subtracting the net effect of cost and price change from the 
over-all margin change figure defined above. 

The controller's first attempt was discussed and rejected by the 
executive committee. The vice-president in charge of sales said that 
the change in marketing costs from 1954 to 1955 as stated in the 
comparison of operating results (Exhibit 1) was clearly $18,189, not 
$88,490, as shown in Exhibit 2. He further pointed out that part of 
the Bulk Plant and Jobber Expense within marketing costs was allo- 
cated to each district in proportion to its gallonage. As far as he 
could see, the formula in Exhibit 2 made no provision for the result- 
ing effect of a change in volume. 

Another member was concerned about the apparent discrepancy 
between the over-all change in gross margin and the net change 
resulting from changes in price and cost. The over-all gross 
margin change resulted from multiplying the difference between 
the 1954 and 1955 gross margins per gallon by the 1955 gallon vol- 
ume. On the other hand, the change in net profit resulting from a 
change in price was calculated by multiplying the change in individ- 
ual product prices by the respective 1955 gallon volumes. 

As he saw it, the gross margin per gallon figures used to compute 
the over-all result of a change in gross margin were averages 
weighted by the gallon volumes of individual products for 1954 and 
1955 respectively. Yet when the over-all result was broken down to 
price and cost effects, 1955 gallon volumes were used to weight the 
difference between individual product margins, a procedure which 
was equivalent to weighting product margins for both years by 1955 
gallon volumes. This procedure he regarded as suspect, even disre- 
garding the fact that the 1954 margin average used in the over-all 
margin calculation was weighted by 1954 product volumes. 

The controller himself was dissatisfied with his first approach for 
still a different reason. He wondered whether it was realistic or useful 
to calculate the change in net profit resulting from a change in vol- 
ume on the assumption of a constant net income per gallon. In his 
experience many marketing costs tended to remain constant with 
changes in volume. In consequence, cost per gallon tended to fall as 
volume increased, and net profit per gallon tended to increase. 

The controller therefore determined to try again. Three different 
approaches embodying volume change calculations based on the 
assumption of constant gross margin per gallon rather than constant 



342 THE ROLE OF FINANCIAL ANALYSIS 

net profit are shown in Exhibit 3. Again the causes considered were 
volume, seHing price, cost of goods sold, product mix, and marketing 
cost. The change in district profit due to marketing cost was the 
same in each approach ( Exhibit 4 ) .^ 

Which of the analyses presented do you think most useful? 

Suggest how this kind of report could be used by operating manage- 
ment. 

-t: 



2 Differences in the net change in net income resulting from the several methods 
were due to rounding prices, costs, and gross margins per gallon. 



BORAH PETROLEUM COMPANY 



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38 



CLARK CHEMICAL COMPANY 

The Controller's Duties 

This case deals with a question of jurisdiction as between the con- 
troller and operating management. It involves a fundamental dis- 
agreement as to the role of the controller. 

The Clark Chemical Company had just completed a management 
reorganization. Under the plan adopted, the organization structure 
had been changed from a functional one, with vice-presidents of 
sales, manufacturing, legal, and industrial relations all reporting to 
the president, to a divisional setup. Four operating divisional vice- 
presidents, each with responsibility for a group of products, now 
reported to the president. Each vice-president had "profit and loss 
responsibility" for his division and corresponding authority, subject 
only to such restrictions as maximum limits on capital expenditures, 
legal and patent matters, and general company policy matters. A 
chart of the new organization is shown in Exhibit 1. 

EXHIBIT I 

Organization of the Clark Chemical Company 



BOARD OF DIRECTORS 



EXECUTIVE VICE-PRESIDENT 



OPERATING DIVISIONS 



VICE- 
PRESIDENT 

(SAM JOHNSTON) 



B 
VICE- 
PRESIDENT 



VICE- 
PRESIDENT 



VICE- 
PRESIDENT 



INDUSTRIAL 
RELATIONS 



ACCOUNTING 



ADMINISTRATIVE 
SERVICES 



349 



350 



THE ROLE OF FINANCIAL ANALYSIS 



The Clark Chemical Company was currently celebrating its fiftieth 
anniversary; during the fifty years of its life the volume of the com- 
pany's sales had grown from a few thousand dollars to over thirty- 
seven million dollars. This growth had come through developing and 
specializing a series of chemical products for industrial users. 

The Accounting and Financial Function 

At about the same time that the organizational changes were being 
made, the company employed Sidney Green to head its accounting 
and finance function. Mr. Green came to the company from a firm of 
similar size in which he had acted as assistant controller and assistant 
treasurer. He was known by his associates as a man who had some 
firm ideas as to what a good controller organization should do in a 
decentralized operation and was aggressive in advancing those ideas. 
As one of his first steps he worked out the organization of his own 
unit, as shown in Exhibit 2. He was able to staff each section with 
an able young man having somewhat similar ideas concerning the 
appropriate role of the controller in business management. 

EXHIBIT 2 

Finance and Accounting Organization 



FINANCIAL 
PLANNING 

AND 

ANALYSIS 

(JOHN KAY) 



CONTROLLER AND TREASURER 
SIDNEY GREEN 



ACCOUNTING 

RECORDS 

AND 

STATEMENTS 



SYSTEMS 

AND 

PROCEDURES 



INTERNAL 
AUDITING 



INSURANCE 
CREDIT 
BANKING 



The next step the new controller took was to ask each of his sec- 
tion heads to submit a program for carrying out the responsibilities 
of his section. At a series of staff meetings these programs were pre- 
sented and discussed. These meetings provided an opportunity for 
each section to gain an understanding of the whole job to be done; 
they also facilitated the elimination of major duplications and the 
covering of areas where gaps occurred. 



CLARK CHEMICAL COMPANY 351 

The Problem 

The Financial Planning and Analysis section of the controller's 
office submitted as its program the report shown in Exhibit 3. This 
program was approved by Mr. Green, the controller. John Kay, the 
head of the Financial Planning and Analysis section, immediately 
began to work out detailed plans to carry out his program. As noted 
in Part V of Exhibit 3, he undertook to develop both a written and 
oral report to the executive vice-president covering the results of 
monthly operations for each division in the company. Mr. Kay had 
selected a number of men in his section and assigned to each of them 
the responsibility for getting familiar with operations of a particular 
division. After monthly operating statements had been prepared, 
the individual responsible for each division set out to prepare an 
analysis of the division for which he had responsibility. To do this 
he frequently called on members of the operating divisions for ex- 
planations, forecasts, and various other kinds of information. 

After this plan had been in operation for several months, Mr. 
Green attended a management meeting of the executive officers and 
operating vice-presidents. When the meeting was opened to general 
discussion, the following discussion took place. 

SAM JOHNSTON ( Vlce-Presideiit of Division A) : Mr. President, I have a bone 
to pick with Sidney (controller) here, and I might as well get my gripe out on 
the table. I object to the way Sidney's man, Kay, goes about getting explanations 
of monthly operating results. Not that he's obnoxious or anything, I just don't 
approve of the whole idea. First, we have to tell him what he needs to know 
and this takes time. Then he goes back to his office and writes up what we have 
told him. Secondly, and more important, is the management philosophy in- 
volved. I believe each operating division should make its own report and ex- 
planations of what happened last month. The controller's office should furnish 
us the statements and we should do the analysis and explaining. Not only is 
this easier, but it's part of our job. We should have to explain to the executive 
vice-president, and we need to know anyway to run our department well. Well, 
that's quite a speech, but it's how I feel! 

SIDNEY green: Am I clear in thinking you don't object to Kay's or his men's 
behavior, just the principle involved? 

SAM JOHNSTON: That's right. They are a nuisance but pleasant about it. 

SIDNEY GREEN: Dou't you think in time Kay's men would learn your operation 
and then they could help you? After all, we've only been doing this a few 
months. 

SAM JOHNSTON: We will take all the help we can, if it doesn't cost anything, 
but, on this point, we are helping you to do what we have to do anyway. 



352 THE ROLE OF FINANCIAL ANALYSIS 

SIDNEY GREEN: You mean you think it is not the duty of the controller to 
report on and analyze the results of operations of the divisions? That's funda- 
mental to good control. 

SAM JOHNSTON: Absolutely! It's not the controller's job to analyze operations 
and report to the boss. That's my job. Now, I agree that you have a responsi- 
bility to the boss. It seems to me your job should be to be sure we are using 
the right figures. Further, I can accept the idea of your reviewing our explana- 
tions and analysis, and reporting whether you agree with us. Your function 
though would be a review one. Now that we are in this discussion, I'd sure 
like to get a decision from the president on this point. 

As the president, what position would you take on this question? 



EXHIBIT 3 

Financial Planning and Analysis Program 

I. Work with top management and divisions in developing projections ol 
business operations and setting goals. 

a. Annual Plan or Budget -,' ' 

b. Five-Year Forecast 

c. Cash Requirements 

d. Capital Expenditure Program 

II. Interpret management plans in financial terms. Make or assist in eco- 
nomic studies of proposed facility and equipment investments, research 
programs, markets, industries, and possible company acquisitions to pro- 
vide guidance to top management and divisions. 

a. Estimate of research project cost, elapsed time, anticipated results. 

b. Estimate of plant and facility start-up cost, volume requirements, 
payoff period, return on investment. 

c. Estimate of market development cost, elapsed time. 

d. Examine capital structure of companies desirable for acquisition 
and evaluate profitability. Recommend financial terms for pur- 
chase. 

e. Other studies as needed. 

III. Appraise current investments and operations indicating where financial 
improvements might be made. 

a. Receivable balances and terms. 

b. Inventory levels and evaluations of content related to sales out- 
look. 

c. Product line P & L's and investment. 

d. Cash balances and working capital levels. Make short term pro- 
jections. 



CLARK CHEMICAL COMPANY 353 

IV. Work with operating personnel in developing operating goals and setting 
expense controls. Explore methods of maximizing operating margin and 
minimizing investment under various conditions. 

a. Operating margin and return on investment goals. 

b. Departmental expense budgets. 

c. Relationship of expenses to volume— fixed and variable. 

Financial Planning and Analysis Program 

V. Report on current performance related to yardsticks (Annual Budget, 
Departmental Expenses, Capital Expenditure Programs, etc. ) . 

a. In personal meetings, written reports, and Division Heads' Meet- 
ings, report on over-all and divisional results related to Annual 
Budget. Monthly basis. 

b. Capital Expenditure Program— appraise progress during current 
year both as to stage of completion and actual cost of projects. 
Quarterly basis for first six months and monthly thereafter. 

c. Develop and maintain charts to portray trends more effectively. 

VI. Assist in developing long-range plans for the over-all company. 

a. Assist in determining direction of company. 

b. Assist operating divisions in developing divisional plans. 

c. Participate in review of progress. 

VII. Analyze cost data to develop overhead rates for use in pricing inter- 
company transactions and other uses. Provide assistance for developing 
interdepartmental service charges. 

a. Research Department cost rates. 

b. Factory overhead rates. 

c. Others. 

VIII. Maintain competitive company and customer financial data 

a. Appraise interim and annual financial reports and alert manage- 
ment to significant facts or trends. 

b. Become acquainted with operating and financial arrangements of 
other companies for practical application in Clark Chemical Com- 
pany. 

c. Maintain scrapbook of competitive company and customer articles 
found in current periodicals. 

IX. Maintain economic statistics not kept elsewhere in the company. 

Indicated below is the manner in which the Financial Planning and Analysis 
Group would carry out the program. The numerals below correspond directly 
with those on the outline of the program. 

I. This group would, in conjunction with top management, determine the 
necessary information to be requested from the various divisions and 
departments to develop the several plans and programs. The group 



fl 



354 THE ROLE OF FINANCIAL ANALYSIS 

would coordinate the flow of information and physically put the data 
in finished form ready for evaluation. The group, where possible, would 
make constructive suggestions or recommendations concerning the data 
developed and the problems encountered— recommendations both to 
division managers and to top management. 

II. The group would become involved in these special studies most likely 
as a result of a request from division managers or top management and 
would participate at the time of developing the figures and, thus, be in 
a position to see that all financial aspects have been considered. 

III. Projects in this area would be started at the initiation of this group, top 
management, or the divisions with the objective that recommendations 
for constructive action would result. Work on product line studies would 
be done in conjunction with divisional personnel. 

IV. Work in this area would usually take place during budget preparation 
periods or when sudden changes in plans appear imminent. Initiation 
during times other than budget periods would probably come from top 
management or operating personnel. However, this group might recom- 
mend to management changes in the course of action from time to time. 

V. This category covers reporting to top management and divisional per- 
sonnel and would be done at the initiative of the group. 

VI. In the long-range planning area the group should be a participant, con- 
tributing ideas and making necessary studies as well as commenting on 
progress. 

VII. Most of the functions in this area would be performed at the request 
of the operating divisions or staff departments. 

VIII. Functions in this area would be accomplished both at the request of top 
management and divisions and at the initiation of this group. 

IX. The accumulation of economic statistics would be done on a routine basis 
and would be restricted to those statistics not maintained elsewhere in 
the company. 



V 



Date Due 
Returned Due Returned 




il 



658.15 

BUSINESS 
ADM, 



Cases in controllership mam 
658.15H355cC.2 



3 lEbE 03B7E 31D7